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96th Congress
1st Session

COMMITTEE PRINT

f Committee
1 Print 96-IFC3

REPORT

OF THE

SPECIAL STUDY OF THE
OPTIONS MARKETS

TO THE

SECURITIES AND EXCHANGE COMMISSION

December 22, 1978

Printed for the use of the
House Committee on Interstate and Foreign Commerce

96th Congress 1 COMMITTEE PRINT { „ Cof ^r,

1st Session / I Print 96— IFC3

REPORT

OF THE

SPECIAL STUDY OF THE
OPTIONS MARKETS

TO THE

SECURITIES AND EXCHANGE COMMISSION

December 22, 1978

Printed for the use of the
House Committee on Interstate and Foreign Commerce

U.S. GOVERNMENT PRINTING OFFICE
40-940 O WASHINGTON : 1979

For sale by the Superintendent <>f Documents, U.S. Government Printing Office
Washington, D.C. 20402

COMMITTEE ON INTERSTATE AND FOREIGN COMMERCE

HARLEY O. STAGGERS,
JOHN D. DINGELL, Michigan
LIONEL VAN DEERLIN, California
JOHN M. MURPHY, New York
DAVID E. SATTERFIELD III, Virginia
BOB ECKHARDT, Texas
RICHARDSON PREYER, North Carolina
JAMES H. SCHEUER, New York
RICHARD L. OTTINGER. New York
HENRY A. WAXMAN, California
TIMOTHY E. WIRTH, Colorado
PHILIP R. SHARP, Indiana
JAMES J. FLORIO, New Jersey
ANTHONY TOBY MOFPETT, Connecticut
JIM SANTINI, Nevada
ANDREW MAGUIRE, New Jersey
MARTY RUSSO, Illinois
EDWARD J. MARKEY, Massachusetts
THOMAS A. LUKEN, Ohio
DOUG WALGREN, Pennsylvania
ALBERT GORE, Jr., Tennessee
BARBARA A. MIKULSKI, Maryland
RONALD M. MOTTL, Ohio
PHIL GRAMM, Texas
AL SWIFT, Washington
MICKEY LELAND, Texas
RICHARD C. SHELBY, Alabama

West Virginia, Chairman
SAMUEL L. DEVINE, Ohio
JAMES T. BROYHILL North Carolina
TIM LEE CARTER, Kentucky
CLARENCE J. BROWN, Ohio
JAMES M. COLLINS, Texas
NORMAN F. LENT, New York
EDWARD R. MADIGAN, Illinois
CARLOS J. MOORHEAD, California
MATTHEW J. RINALDO, New Jersey
DAVE STOCKMAN, Michigan
MARC L. MARKS, Pennsylvania
TOM CORCORAN, Illinois
GARY A. LEE, New York
TOM LOEFFLER, Texas
WILLIAM E. DANNEMEYER, California

W. E. Williamson, Chief Clerk and Staff Director

Kenneth J. Painter, First Assistant Clerk

Eleanor A. Dinkins, Assistant Clerk

William L. Burns, Printing Editor

(ID

LETTER OF TRANSMITTAL

SECURITIES AND EXCHANGE COMMISSION

^--••^>;

WASHINGTON, D.C. 20549

OFFICE OF
THE CHAIRMAN

February 15, 1979

The Honorable James Scheuer
U. S. House of Representatives
Washington, D. C. 20515

Dear Congressman Scheuer:

I am pleased to transmit herewith The
Report of the Commission's staff's Special
Study of the Options Markets.

\M. Williams
fairman

(HI)

Digitized by the Internet Archive
in 2013

http://archive.org/details/respecialsOOunit

Special Study

of the

Options Markets

SECURITIES AND EXCHANGE COMMISSION
Washington. D.C. 20549

December 22, 1978

To the Chairman

and Members of the Securities and Exchange Commission

It is an honor to transmit to the Commission the Report of the
Special Studv of the Oct ions Markets. The Report describes the find-
ings and recommendations of the Options Study in response to the
Commission's directive set forth in its public release of October 1977. */
The Commission specifically directed the Options Studv to investigate
and studv the listed options markets to determine thu ability of self-
renulatory organizations, including national securities exchanges and
the National Association of Securities Dealers, Inc., to carry out their
requlatorv responsibilities to assure that listed options trading is
occurrinq in a manner, and in an environment, which is consistent
with the maintenance of fair and orderly markets, the public interest,
the crotection of investors and the other objectives of the Securities
Exchanoe Act of 1934.

In oeneral , the Options Study found that options can provide use-
ful alternative investment strategies to those who understand the
complexities and risks of options trading. But, since regulatory
inadeouacies in the options markets have been found, the Options Study
is makina specific recommendations needed to improve the regulatory
framework within which listed options trading occurs and to increase
the ixotection of public customers.

The Report is divided into eight chapters. The Introduction includes
a summarv of the Options Study's conclusions and recommendations. Chapter
II describes some fundamental uses of options. Chapter III describes the
wavs that market professionals use listed options. Chapter TV describes
and evaluates the market surveillance systems of the self -regulatory
organizations. Chapter V discusses options selling practices. Chapter
VT analyzes the adeouacy of self-regulatory organization oversight
of broker-dealer firms. Chapter VTI describes financial regulation
in the options markets. Chapter VTII discusses certain market structure
issues that proposals to initiate new options trading programs have
raised .

*/ Securities Exchange Act Release No. 14056 (October 17, 1977).

(V)

While the best of the market surveillance techniques that have
been developed would provide a self-requlatory organization with a
aeneral ability to detect known improper trading patterns, the Options
Study found that numerous improvements must be made in this area to
maximize the effectiveness of self-regulatory organization surveillance.
First, the surveillance information available to each self-regulatory
organization must be improved. In addition, surveillance information
must be better shared among the self -regulatory organizations and
surveillance programs should be better coordinated. Further, each
self-renulatory organization must evaluate its own surveillance
proqram to assure that it is using the most sophisticated market
surveillance techniaues available. New and additional data also
need to be developed to relate options trading to underlying stock,
tradinq not only for current market surveillance purposes, but also
to study the patterns, relationships and effects of related stock
and options tradinq.

The Options Study found numerous instances of sales practices
abuses in which registered representatives told investors of possible
rewards they miaht expect from options without simultaneously warning i
them of the risks inherent to options trading. Often, inadequately
trained registered representatives recommended options strategies
to their customers which it is doubtful that the salesmen, much less
their customers, understood. The most prevalent source of sales
practice abuses appeared to occur in broker-dealer firms that
encouraoed or permitted their registered representatives to recommend
options trades to their customers before the firms had in place appro- \
nriate supervisory controls to protect their public customers.

Mthough the primary responsibility for assuring that options
participants are both informed and treated fairly rests with the
brokerage firms, the self-regulatory organizations are required to
see that these industry-wide standards are established and met by
their member firms. Serious shortcomings were found in the self-
requlatorv organizations' oversight programs to detect and prevent
sellinq practice abuses of their member firms. Representatives of
the self-renulatory organizations demonstrated to the Options Study
staff their awareness of many of these regulatory problems and their
willingness to seek solutions on a continuing basis. The Options Study
believes that its recommendations for improved internal controls
by brokerage firms, enforced by self-regulatory organization rules
and actively overseen by the Commission will protect investors from
many of the selling practices abuses currently found in the options
markets, while at the same time fostering better understanding of
the risks of options trading by public customers.

VII

The Ootions Study also found that in the area of oversight of
broker-dealer retail activities, as v«ll as market surveillance, there
was a need for greater cooperation and sharing of information among
the self-renulatory organizations to avoid present duplication of
activities and to substantially improve the effectiveness of the
combined requlatory efforts. In order to facilitate this cooperation,
representatives of the self-regulatory organizations formed a Self-
Reaulatorv Conference to consider ways in which to improve the
coordination of their activities and to share market surveillance
and other requlatory data. To be successful, this effort will require
the full cooperation of the self -regulatory organizations and the
suoDort and oarticipation of the Commission.

In aeneral', the recommendations of the Cptions Study call for action
by the self-regulatory organizations to improve their own procedures
and those of their member firms. Placing primary responsibility on the
self-requlatory orqanizations reflects the importance of self-regulation
in the requlatory oattern of the securities industry. If the self-
renulatory orqanizations do not act, the Options Study recommends that
alternative action should be taken by the Commission through its authority
over the self-regulatory organizations and through its own enforcement
rowers.

Fbr the most oart, the Ootions Study has used examples of actual
abuses to demonstrate the problems which its recommendations are expected
to correct. The Ootions Study has not generally mentioned firms or indi-
viduals bv name, nor has any attempt been made to quantify the extent of
the abuses. The goal of the Options Study has been to recommend improvements
where requlatorv lapses have permitted significant abuses to occur or where
additional abuses could occur if corrections are not made. VJhile some
recommendations may increase costs to the self-regulatory organizations and
broker-dealers, the Options Study has made every effort to develop the least
costly solutions and has sought means to reduce current duplicative regula-
torv efforts in some areas so as to offset increased efforts required in
other areas.

Throughout its work, the Options Study has been aided by the
cooperation of the self-regulatory organizations, the Securities
Industrv Association and broker-dealer firms. In many instances,
the Ootions Study imposed substantial extra burdens on both organiza-
tions and individuals. Without the assistance of a number of indi-
viduals who made their expertise freely available, the Options Study
could not have completed its task within the time period that the
Commission established. Except as otherwise noted, staff investiga-
tions were concluded by the end of August 1978, although an effort
has been made to take into consideration any subsequent improvements
reported bv the self-requlatory organizations.

VIII

In addition, durinq the period of the Options Study, a number
of improvements were made in the regulatory programs of the self-
reaulatorv orqanizations. Some of these improvements may have
been coincidental with the Options Study's work. Others, however,
mav have represented an acceleration of improvements that would
otherwise have occurred. Unouestionably, many improvements resulted
from the increased attention given to finding solutions to deficiencies
by both the securities industry and the Commission during the moratorium.

While much of the Report focuses on the deficiencies that were
found in the regulation of the options markets, credit must be given
to the self-regulatory orqanizations for the regulatory and surveillance
work that they have accomplished since listed options trading began
in 1973. Many recommendations of the Options Study are designed to
extend to all self-regulatory organizations techniques which were
developed and are already employed by one or more of the self-
requlatorv orqanizations.

In view of the scope and complexity of the matters covered in
the Report, the Options Study cannot be viewed as providing the
definitive answers to all of the questions which need to be answered.
In accordance with the Commission's directive to concentrate on
the regulatory aspects of the self-regulatory organizations, the
Options Study's recommendations are designed to be effective in the
options markets as they currently exist. Thus, in many respects, the
Options Studv is merely a beginning. Its efforts should be continued
as a part of a regular Commission program of oversight of the options
markets. Some of the Options Study's recommendations are designed
to continue this effort bv developing new sources of data so that
the Commission and self -regulatory organizations can examine potential
oroblems which the Options Study could not analyze because adequate,
usable data was not available.

The Ootions Study did not undertake a study of certain broader
issues. The Options Study, for example, did not undertake its own
broad economic studies of the effect of options on the trading in
the underlyinq stocks or on the capital raising functions of the
securities markets, but instead has referred to studies performed
bv others. As the options market matures, and as additional infor-
mation becomes available, further studies will be needed. The Options
Studv did not attempt to compare the specialist and competing marketmaking
svstems used by the options exchanges. Similarly, while the Options
Studv has made recommendations to improve the ability of those who
make markets on the floor of an exchange to use credit in their
marketmaking activities on terms more favorable than public customers,

it did not consider whether there should be changes in the present
system of credit regulation which might make such favorable treatment
unnecessary or inadvisable.

A concerted effort has been made to simplify the description
of the matters covered in the Report and to avoid technical jargon
and extensive references to rules and regulations and legal precedents.
Unfortunately, the complexity of the subject matter has prevented
us from meeting this goal consistently. The pronoun 'he,' rather
than other alternatives, has been employed throughout this Report
to avoid the awkward reference 'he/she'.

While the staff of the Options Study is responsible for the
Report's contents, it was aided greatly by other members of the
Commission's staff. It drew upon the time and resources of the
various Commission Divisions in Washington and upon all of the
Commission's Regional Offices. Much information, along with ideas
which form the core of the Options Study's recommendations, was
develoDed from these sources. A list of Commission staff personnel
who contributed to the Options Study appears at the end of this
letter under "Acknowledgments." Special mention, however, must
be made concerning the extensive and continuing support of Andrew M.
Klein, Sheldon Raopaport, and Kathryn B. McGrath of the Division of
Market Regulation, Stanley Sporkin, Wallace L. Timmeny, Theodore A.
Levine and Ira H. Pearce of the Division of Enforcement, and Ralph C.
Ferrara and Robert C. Pozen of the Office of the General Counsel.
The Options Study was organized and directed by Martin L. Budd until
June 16, 1978, when he resigned as Director for personal reasons.

Re>pec1^2lly submitted,
Richard L. Teberg f

Director

THE SPECIAL STUDY OF THE
OPTIONS MARKETS

Director :

Richard L. Teberg

Martin L. Budd (before June 19, 1978)

Chief Counsel: Martin Moskowitz

Senior Economic Advisor: Gene L. Finn

Assistant Director - Self Regulatory Systems: Van P. Carter

Assistant Director - Sales Practices: Thomas J. Loughran

Assistant Director - Trading Practices: Kenneth S. Spirer

Financial Regulation and Credit Specialist: Robert L. Smith

Special Counsel: Richard I. Weingarten

Special Assistant to the Director: Marianne K. Smythe

Staff Attorneys:

Lawrence R. Bardfeld Sanmy S. Knight

M. Blair Corkran, Jr. John E. Larouche

Ray J. Grzebielski Gary G. Lynch

Richard G. Ketchum Janet R. Zimmer

Senior Financial Analyst: Dennis G. Shea

Economic Liaison (until June, 1978): Richard J. Morrisey

Statistical Consultant: Robert H. Menke

Editorial Consultant: Lael Scott

Staff Assistant: Rhoda S. Clavan

Interns :
Brian Timken
William T.K. Dolan

Secretaries:

Den ice S. Dishman Rosalie C. Moyer

Cletha I. Francis Lorna Olsen

Gail D. Hogg Donna M. Phelps

Nora J. Huke Pamela M. Switzer

Valerie L. Krohn Sandra L. Washington

Susan E. Morrow

(XI)

XII

ACKNOWLEDGMENTS

The Options Study received assistance from numerous segments of
the Commission's staff. Regretably, it is not feasible to acknowledge
the contribution of each person individually. A special note of
appreciation is given, however, to the staffs of the following offices
and divisions and to the particular individuals noted below:

Headquarters Staff
Directorate of Economic and Policy Research Division of Market Regulation

Roger W. Spencer
Charles W. Bryson
Peter G. Martin
Ha jo Lamprecht
Johnathan L. Hunter
Eileen F. Whelan

Division of Corporation Finance

Richard H. Rowe
Mary E. T. Beach
J. Rowland Cook
Paul A. Bel v in
Timothy M. Harden

Division of Enforcement

Stanley Sporkin
Theodore A. Levine
Edward D. Herlihy
Ira H. Pearce
Richard V. Norell
Paul W. Bodor
Joseph Cella
Harold L. Hal pern
John F. Hartigan
Stanley B. Whit ten

Office of Consumer Affairs

Justin P. Klein

Office of Data Processing

John D. Adkins
Richard T. Redfearn

Office of Administrative Services

Richard J. Kanyan
James T. Willis

Andrew M. Klein
Sheldon Rappaport
Kathryn B. McGrath
Lloyd H. Feller
Douglas S. Scarf f
Mark 0. Fitterman
Roger D. Blanc
Nelson S. Kibler
Harry S. Day
Harry Melamed
Michael P. Maloney
Jessica Licker Osborn
Robert J. Bretz
Leonard L. Unger
Gene E. Carasick
Herbert F. Brooks, Jr.
Therese M. Haberle
Marc L. Weinberg
Barbara E. Polonsky
William J. Finegan

Office of the General Counsel

Ralph C. Ferrara
Robert C. Pozen
John P. Wheeler
Eric D. Roiter
Theodore Bloch

Office of Public Affairs

Andrew L. Rothman

Office of the Secretary

George A. Fitzsimmons
Shirley E. Hollis
Charlene C. Derge
Raymond J. Kramer

Office of the Executive Director

Benjamin Milk
George G. Kundahl
James A. Clarkson, III

XIII

Atlanta

Regional and Branch Offices
Denver

Jule B. Greene
George M. Callahan
John T. E. Van Deusen
Kenneth E. Newman

Robert H. Davenport
Harold M. Golz

Fort Worth

Boston

Willis H. Riccio
Arthur A.. Carr
Raymond D. Vaillancourt
Thomas P. Kehoe
Katherine W. Keane

Chicago

William D. Goldsberry
William M. Hegan
Joan M. Fleming
Ronald P. Kane
Michael J. O'Rourke
John R. Brissman
Ellen E. Douglass
Steven D. Edelson
Diane Fischer
Joyce Lynch
David M. Matteson
Peter B. Shaeffer

New York

William D. Moran
Edwin H. Nordlinger
Sheldon G. Kanoff
Carmine L. Asselta
Michael T. Gregg
Paul S. Maco
Bernard Schwartz

^Philadelphia

Thomas H. Monahan
Sheldon J. Sandler
Daniel F. McAuliffe
John A. Galante

* Branch Office

Michael J. Stewart
Wayne M. Secore
Gordon R. Cox
James H. Perry
Mary Lou Felsman

Los Angeles

Gerald E. Boltz
Hillel Conn
Israel Mattatia
Raoul McDuff
Joel M. Bolten

'Miami

William Nortman
Charles C. Harper
Charles D. Hochmuth

Seattle

Jack H. Bookey
C. Arnold Taylor
John R. McNeall

Washington

Paul F. Leonard
Edward A. Kwalwasser
Richard A. Mangini
Robert W. Martinson
Louis A. Perrotto

rSan Francisco

Leonard H. Rossen
Steven N. Mochtinger
Harry M. Jones
Ming Suen

GLOSSARY

It is hoped that the following brief explanations of various terms
and acronyms used in the Option Study's report will be helpful, particularly
to the non-professional reader, in understanding the text of the report.
Of course, no attempt has been made here to formulate legal definitions.

Account Statements

Brokerage firm statements sent periodically
to customers, usually itemizing all securities
held in an account and the cash balance.

At-the-money

When the option's exercise price is the same
as the current trading price of the underlying
stock.

AMEX

American Stock Exchange, Inc., on which stocks
and listed stock options are traded.

Arbitrage
Audit Trail

Trading to take advantage of a perceived temporary
pricing disparity between two securities.

The physical record of trading information identifying,
for example, the brokers participating in each
transaction, the firms clearing the trade, the
terms and time of the trade and, ultimately
and when applicable, the customers involved.

Bearish

An investor's attitude when he believes the market
or a particular security's price will decline.

Bear Market

A market in which the general trend of securities
prices is down.

Bear Vertical
Soread

A hedged strategy employed when an investor expects
a decline in the security price but at the same
time seeks to limit the potential loss if he is
wrong. This spread requires the simultaneous
purchase and sale of options of the same class
and expiration date but different strike prices —
e.g., if call options are "spread," the purchased
option must have a higher exercise price than
the sold option (for a higher premium on the
sale) .

Beta

A measure of a stock's sensitivity to the movement
of the general market.

(XV)

XVI

Bid/Ask

The market quotation for a stock or option.
A bid is the price at which a potential buyer
is willing to buy. An ask is the price at which
a potential seller is willing to sell i.e. , his
asking price.

Block Trade

A single transaction involving a large number
of shares or option contracts. The NYSE defines
a block as a transaction of 10,000 shares or
more.

Broker-Dealer

A securities firm, generally one that does
business on behalf of customers (as a broker)
and for its own account (as a dealer).

Bullish

An investor's attitude when he believes the
general market or a particular security's
price will advance.

Bull Market

A market in which the general trend of securities
prices is up.

Bull Vertical
Spread

A hedged strategy used when an investor expects
that the price of a security will go up but at
the same time seeks to limit his potential
loss should his judgment be in error. This
strategy involves the simultaneous purchase
and sale of options of the same class and
expiration date but different strike prices —
e.g. , if call options are "spread," the purchased
option must have a lower exercise price than
the sold option.

Butterfly Spread : An options position involving the simultaneous purchase
and sale of options in the same class, with the same
expiration date, so that for every two options
sold, two options-one with a higher exercise price
and one with a lower exercise price-are bought.

Call Option

A contract giving the holder the right to
buy a specified number of shares (usually
100) of the underlying stock at a specified
price within a specified period of time.

XVII

Called

Another term for "exercised" when the option
is a call. The writer of a call must deliver
the indicated underlying stock when tne option
is exercised or called.

Capping

Effecting stocK transactions shortly prior to an
options expiration date to depress or prevent

a rise in the price of a stock so that previously
written call options will expire worthless and
the premium received therefrom will be protected.

CBOE : Chicago Board Options Exchange.

Class of Options : Options contracts of the same type (put or call)
covering the same underlying security.

Clearing Firm : A broker-dealer member of the Options Clearing
Corporation (OCC) engaged in the business of
clearing, through OCC, listed options trans-
actions for its own account or on behalf of
other firms. Called a "marketmaker clearing
firm" when it clears for marketmakers .

Closing Purchase : A transaction in which an option writer terminates

his obligation by buying an option with the identical
terms as the option previously sold.

Closing Sale

A transaction in which the holder of an option
liquidates his position by selling an option
having the same terms as the option he previously
purchased .

Commissions

A fee charged each customer by his brokerage firm
for stock or options transactions made on his
behalf.

Compliance Programs:

Activities conducted by self -regulatory organizations
to detect and discipline violations of the Federal
securities laws and securities industry rules con-
cerning retail sales and certain other practices of
their member firms and employees. Broker-dealers
conduct similar programs respecting the activities
of their own sales personnel.

40-940 O - 79 - 2

XVIII

Conversion

Cover

Delta Factor

An arbitrage technique involving buying an underlying
stock, selling the related calls and buying puts
corresponding to the calls.

A writer's purchase of stock to deliver to the holder
when the holder exercises a call option and the writer
does not then own the stock he wrote the call on. Also,
to purchase options to eliminate a short options position.

The amount of change in an option's theoretical value
relative to small changes in the price of the underlying
stock over a short period.

Demand
Equity

The degree of investor interest in purchasing a security.

The net worth of an account, determined by subtracting
the market value of short security positions and
the debit balance (if any) from the market value
of long security positions and the credit balance
(if any). Equity represents ownership in the
account.

Equity Securities : Corporate securities, usually common stocks, which
represent ownership in the issuing corporations.

Excessive Trading : Transactions that do not have a valid investment
purpose but, instead, are made for the purpose
of generating commissions for the salesman or
brokerage firm. Often called "churning."

Exercise Price
(Striking Price)

Expiration Date

Fictitious Trades

Tne price per share at which the option buyer may
buy, in the case of call, or sell, in the case of
a put, 100 shares of the underlying stock.

The date on which an options contract expires. The
date is listed by month only (e.g. January, April,
July) and refers to the Saturday following the
third Friday of the month.

Reports of transactions submitted to a price re-
porting system of an exchange but which, in
fact, did not occur.

XIX

Firm Proprietary
Trading

Frontrunning

Haircut

Hedging

Holder
In-the-Money

Initial Margin

Securities transactions entered into by a broker-
dealer for its own account.

The practice of effecting an options transaction based
upon non-public information regarding an impending
block transaction in the underlying stock, in order
to obtain a profit when the options market adjusts
to the price at which the block trades.

An amount deducted from a broker-dealer's net worth
in determining its net capital. It is a percentage
of the value of a broker-dealer's marketable secu-
rities and is designed to provide a cushion of capital
in the event of adverse price movement. The percentage
amounts generally range from 1/8 of a percent for
commerical paper to 30 percent for common stock.

Lessening a risk of loss by, for example, offsetting
a long position in one security with a short position
in a related security, or vice-versa.

Person who purchases an option, also called a buyer.

When the exercise price for a call is lower than the
current market price of its underlying stock;
or for a put, when the exercise price is higher
than the stock's current market price.

A deposit a customer must make in accordance with
Regulation T as a result of a securities transaction.
Naked call writers, for instance, must deposit cash
or margin securities whose loan value equals at
least 30% of the value of the underlying securities,
less the proceeds of the option sale.

Institutional
Investors

An investment company, bank, insurance company,
endowment, pension fund or other organization
which has substantial funds committed to securities
investments.

Intrinsic Value : The amount by which the current market price of the
(of an option) underlying stock exceeds the exercise price of a call
option, or is less than the exercise price of a put.

Listed Option

An option traded on a national securities exchange.

Long Option
Position

Maintenance Margin

Marketmaker

Mini-manipulation

MSE
NASD

The number of option contracts of a particular
option series held in an individual account or
group of accounts.

The minimum amount of margin (equity) that must be
maintained in a general account as required by
exchange or association rules.

A dealer who holds himself out as being willing
to buy and sell securities for his own account
on a regular or continuous basis. On the options
exchanges, certain rules are designed to require
such market participation for members dealing on
their floors, and such members may be called
competitive marketmakers , registered options
traders, etc. See "Specialist" below.

An attempt to influence, over a relatively small
range, the price movement in a stock to benefit
a previously established. opt ions position.

Midwest Stock Exchange.

National Association of Securities Dealers, Inc.,
a self-regulatory organization of broker-dealer
members involved in the over-the-counter securities
markets .

Naked (Uncovered)
Option Writing

An option writing position collateralized by cash
or by securities unrelated to those on which
the stock option is written.

Near Term
NYSE

Close to expiration.

New York Stock Exchange, on which most of the stocks
underlying listed options are traded.

OCC

Options Clearing Corporation.

XXI

OCC Prospectus : The required disclosure document for listed options.
Exchange rules require that a current prospectus
be provided to options customers at or prior
to the time their accounts are approved for ■
options trading.

Open Interest

The number of listed options contracts of a class
outstanding at any given time.

Opening Purchase
Transaction

A transaction in which an investor becomes
the holder of an option.

Opening Sale
Transaction

A transaction in which an investor becomes
obligated as the writer of an option.

Option

A contract which allows the buyer, by exercise,
to buy or sell stock (usually in 100-share units)
at a certain price (exercise or striking price)
over a certain period of time, regardless of how
high or low the price of the stock (the underlying
security) moves during that time.

Options (OTC)

Non-listed put and call options whose expiration dates
and exercise prices are not standardized; OTC options
are not cleared or guaranteed by the Options Clearing
Corporation (OCC).

Out-of-tne-
Money

When the exercise price for a call is higher
than the current market price of the underlying
stock or, for puts, when the exercise price is
lower than the stock's price.

Parity
Pegging

When the premium (market value) of an option at
least equals its intrinsic value.

Eft stock transactions to prevent a decline
in ti. -rice of the stock so that previously written
put opt ns will expire worthless, thus protecting
premiums previously received.

XXII

Performance
Reports

Written materials used by sales personnel to present
to options customers the results of actual options
transactions, usually in the form of a profit and
loss statement.

PHLX

The stock exchange headquartered in Philadelphia
on which stocks and listed options are traded.

Position

Adjustments

Changes initiated by clearing member firms in their
customer, market maker or firm proprietary options
position records maintained by OCC.

Position Limits : Limits set upon the number of options contracts
relating to an underlying security which an
investor may own or control.

Prearranged Trades

Transactions on the floor of an exchange which
are effected pursuant to a prior agreement among
the parties. An order to buy or sell an option
is entered with the knowledge that another person
will enter an order of substantially the same
size, at substantially the same time, and at
substantially the same price. Two variations
are called "wash sales" and "trade reversals."

Premium

Professional
Traders

The money paid for an option contract by a buyer
and received by the option's writer. The premium
is kept by the writer whether or not the option
is exercised.

Persons who earn their livelihood from buying
and selling securities on the floor of an ex-
change, such as an institutional money manager,
or a dealer trading from off -floor, etc.

PSE

Public Customers

Pacific Stock Exchange. Listed options are traded
on the San Francisco floor of this exchange.

Persons who pay commissions to effect securities
transactions through broker-dealers, and who are
not professional traders.

XXIII

Put Option

A contract giving the purchaser the right to sell
a specified number of shares (usually 100) of
the underlying stock at a specified price within
a specified period of time.

Renistered
Representative

A salesperson employed by a brokerage firm who
handles customer accounts.

Regulation T

The Federal Reserve Board rule governing, among
other things, the amount of credit (if any)
that initially may be extended by a broker to
his customer on a securities transaction.

Restricted Options

An options series in which prohibitions on
opening purchase and sale transactions are in
effect.

Reverse Conversion

An arbitrage technique involving the short sale
of an underlying stock, the purchase of related
calls and the sale of puts corresponding to the
calls.

Registered Options
Principal ("ROP")

An employee of a broker-dealer firm who is
responsible for supervising the customer
options account activities. He is required
to pass a special qualifying examination in
options.

Seal pi na

An option marketmaking strategy involving the
purchase of options at the bid price and sale
at the asked price in order to earn the differential
or spread, sometimes referred to as the "jobber's
turn" .

Secondary Market : Provides for the selling and/or buying of
previously bought or sold options through
closing transactions.

Self -Ren ulatory
Conference

A series of meetings commenced in August, 1978,
attended by representatives of the self-regulatory
organizations to discuss issues raised by the
Options Study.

XXIV

Series

Options of the same class having the same
exercise price and expiration date.

Short Option
Position

The open position of the writer or seller of an
option.

Short Term

Of limited duration. All listed option trading is
generally referred to as short term because options
expire in a maximum of nine months.

SIAC

Securities Industry Automation Corp. An organization
jointly owned by the American Stock Exchange and
the New York Stock Exchange that acts as facilities
manager and data processor for various securities
related activities of the SRO's.

SIPC

Securities Investor Protection Corp. A non-profit
membership corporation established by Congress to
afford certain protection against financial loss
to customers of its members which fail. Its members,
with certain exceptions, are all registered brokers
or dealers.

Specialist

A member of a specialist exchange (e.g., Amex, NYSE),
as distinguished from a marketmaker exchange, who is
permitted to deal on the exchange floor for his own
account while at the same time effecting transactions
as broker for the accounts of others. For some
purposes, however, marketmakers are sometimes
referred to as specialists.

All specialists have certain obligations to maintain
fair and orderly markets. Among the benefits they
enjoy by virtue of their specialist status is special
margin treatment under the Federal Reserve Board
Regulations T and U.

Spread

The difference between one price and another (for
example, between the bid and the ask prices); or
an options position created by buying and selling
of different series of options of the same class.

SRO

Self-regulatory organization — includes the national
securities exchanges and the National Association
of Securities Dealers (NASD). Each is required
to regulate and oversee its broker-dealer member
firms and their employees.

XXV

Straddle

Striking Price
Suitability

A combination option position consisting of one
put and one call of the same class. Either option
is exercisable or salable separately and the exercise
prices and expiration dates are usually identical.

Also called exercise price,
an option is exercisable.

The price at which

Suitability is a concept designed to protect
customers by obligating brokerage firms and
registered representatives to recommend for a
customer only those securities transactions which
they reasonably believe are not unsuitable for the
customer in light of his financial situation and
needs.

Surveillance
Programs

The methods by which the self -regulatory organizations

detect trading practices that

may be inconsistent with the Securities Exchange

Act, the rules thereunder, and the rules of those

organizations.

Transactions Costs :

Expenses incurred in buying or selling securities,
the most important of which are commissions.

Uncovered (Naked) : A writer who does not own the underlying stock
Writer which is the subject of an option.

Underlying Stock : The stock suoject to being bought or sold upon
exercise of an option.

Upstairs Dealer
Firms

Worksheets

Securities dealers that initiate exchange trans-
actions from off the floor of the exchange.

Written materials used by sales personnel to
portray to customers the potential profits and
risks of proposed options transactions.

Writer

The seller of an option contract.

COX TENTS

Page

Letter of transmittal m

Digest of report v

The special study of the options markets staff list xn

Glossary xv

CHAPTER I— Introduction:

A. The growth of listed options trading 1

B. Effect or listed options trading on the securities industry 9

C. Studies of economic effects of listed options trading 12

D. Summary and conclusions of the options study 18

1. Self-regulatory organization systems 19

(a) Market surveillance 19

(1) American Stock Exchange surveillance in-

formation and audit trail 21

(2) New York Stock Exchange surveillance

information and audit trail 24

(3) Firm proprietary and customer trading in-

formation 25

(4) Options clearing corporation position ad-

justments 26

(5) The sharing of surveillance information

and the allocation of regulatory re-
sponsibility 27

(6) Investigation and enforcement 30

(b) Broker-dealer oversight 33

2. Trading practices 37

(a) Professional trading 38

(b) Position limits 40

3. Selling practices 43

(a) Customer protection 44

(1) The OCC prospectus 44

(2) Customer suitability 47

(3) Opening account statements 50

(b) Responsibilities of broker-dealer firms 52

(1) Qualification of registered representatives, .V2

(2) Supervision of registered representatives

and of customer accounts 54

(3) Recordkeeping and communications with

customers 56

(4) Exercise allocations 58

4. Financial structure 58

(a) The Commission's net capital rule 59

(1) Increase of deductions in computing net

capital 60

(2) Net capital deductions for marketmaker

clearing business 62

(3) Marketmaker minimum net capital 63

(4) Financial requirements of upstairs dealer

firms 64

(5) Marketmakers that are OCC members.. _ 66

(b) Options specialist stock credit 67

(1) Stock hedge 68

(2) Limit on stock qualifying for specialist

stock credit 71

5. Market structure 72

(xxvn)

XXVIII

CHAPTER II— Fundamentals of Exchange Traded Options:

A. Characteristics of options 73

1. Conventional OTC options compared to listed options 73

2. The options contract 76

3. Stock price considerations in listed options 82

4. Short-term character of options trading 83

5. Transaction costs 87

6. Options pricing models 90

7. Examples of the effect of options contracts 96

(a) Call option 97

(b) Put option 99

B. Principal strategies 106

1. Introduction 106

2. Ten basic strategies 107

3. Survey of investor use of option strategies 114

4. Writing options for premiums 117

Exhibit I: The relationship between puts, calls, starddles and

stocks 121

CHAPTER III— The Use of Options By Professional Traders:

Introduction 125

1. On floor market participants '. 129

(a) Obligations 129

(b) Privileges 132

(d) Stock/options trading strategies 138

2. Upstairs firms 144

(a) Advantages enjoyed by upstairs firms 144

(b) Arbitrage trading 147

(1) Conversion and reverse conversion arbitrage 148

(a) Conversion arbitrage 149

(b) Reverse conversion arbitrage 151

(2) Hedged short selling 153

(3) Merger or exchange offer arbitrage 155

(4) Discount options arbitrage 158

c. Block trading 159

d. Creation of synthetic puts 163

3. Institutional investors 165

4. Specific trading abuses 169

(a) Fictitious trades 169

(b) Prearranged trading . 170

(d) Stock option manipulation 173

(1) Minimanipulation 173

(2) Capping and pegging 175

(3) Statutory prohibition of manipulation 176

(4) Problems of proof and the need for data 178

(e) Front-running 183

5. Trading rules 189

(a) Position limit rules 189

(b) Restricted options rules 193

XXIX

CHAPTER IV — Self-Regulatory Organization Surveillance of the Stand-
ardized Options Markets:

I. Introduction 197

II. Methodology 201

III. Surveillance infoimation 203

1. The sources of surveillance information 203

2. The organization of capture of suiveillance information. _ 208

(a) Transaction information 208

(b) Clearing information 212

3. Conclusions and recommendations 219

a. Surveillance infoimation 219

(1) AMEX surveillance information and
audit trail 220

(2) NYSE surveillance information and
audit trail 223

(3) Stock market reconstruction 230

(4) Firm proprietary and customer trading
identification 233

(5) Customei account identification 236

(6) OCC position adjustments 238

b. Surveillance techniques 243

( 1) Surveillance techniques and surveillance
information 243

(2) The sharing of surveillance information
and the allocation of regulatory respon-
sibility 244

(3) Improving options exchange surveillance
techniques 252

(4) Uniform repotting requirements 253

IV. Investigation and enforcement 254

1. The CBOE and PSE 255

2. The PHLX 257

3. The AMEX 258

4. The MSE 263

Table 1 — Surveillance data Available 207

Table 2 — Comparison of surveillance data available to surveillance data

captured 218

Exhibits:

1. CBOE Market Data Retrieval Listing (MDR):

A. By Time 265

B. By Price 266

2. Amex options daily journal report 267

3. NYSE daily transaction journal 269

4. CBOE matched transaction listing (MTL) 270

5. NYSE daily reconciliation clearing sheets 271

6. OCC daily position report 273

7. Amex foim 958-C-. 274

8. PSE form OTR-1 275

9. Letter to Richard Teberg, Director, Special Study of the Options
Markets, from the Self-Regulatory Conference, dated October 6,

1978 276

XXX

Appendix Exhibits*:

1. Trading procedures and trade matching operations of the AMEX,

CBOE, MSE, PHLX, PSE, and NYSE; surveillance techniques
of the AMEX, CBOE, MSE, PHLX, and PSE.

2. Sample inspection outline and inspection information request

(CBOE).

3. CBOE marketmaker minimanipulation and capping investiga-

tion (Case No. M 7145).

4. PSE expiration study.

5. CBOE capping investigation (complaint No. M 8018).

6. AMEX capping investigation.

7. AMEX capping investigation.

8. NYSE expiration study.

9. CBOE prearranged trading investigation (complaint No. M 8080).

10. AMEX prearranged trading investigation.

11. CBOE prearranged trading investigation (Case No. M 7052).

12. CBOE fictitious trading investigation (Case No. M 7061).

13. CBOE front-running investigation (Complaint No. M 8078).

14. AMEX front-running investigation.

15. PSE front-running investigation.

16. Inside information investigation.

17. AMEX inside information investigation.

18. CBOE position adjustment investigation (complaint No. M 8098).

19. CBOE position adjustment investigation (complaint No. M 7163).

20. Table A: Exchange surveillance parameters.
Table B: Summary of exchange personnel.
Table C: Exchange surveillance expenditures.
Table D: Options exchange cleared contract volume.

CHAPTER V— Options Selling Practices: page

Introduction 289

A. Registered representative qualification, preparation and motiva-

tion 296

B. Supervision of accounts 314

C. Suitability -336

D. Disclosure documents 369

E . Promoting options — general problems 384

F. Promoting options — specific methods 402

G. Promoting options — investment programs 425

H . Options trading in customer accounts 440

I. Exercise problems 477

CHAPTER VI— Self-Regulatory Organization Oversight of Retail Firms
and Their Associated Persons:

I. Introduction 487

II. An Overview of SRO compliance programs 492

A. Monitoring programs 492

1. Employment and termination of registered re-

presentatives 493

2. Customer complaints .. 494

3. Advertising 494

4. Financial responsibility early warning systems 496

5. Credit monitoring 496

B. Cause examinations 497

C. Routine examinations 498

D. Disciplinary actions 501

*These Appendix Exhibits are available publicly in the Commission's Public Reference Room and,
therefore are not published as a part of this report.

XXXI

CHAPTER VI— Continued page

III. Obtaining compliance information 502

A. Public customers

B. SROs

1. Sharing of information

2. Coordination of compliance programs 1 516

C. Government agencies 518

D. Retail firms 520

1. Accessibility of customer complaints and ac-

count information 520

2. Reporting requirements 524

IV. Deficiencies in SRO examinations 530

A. Limited scope of examinations 530

B'. Poor selection of accounts for review

C. Inadequate depth of account examinations 540

D. Reliance on firms for assistance 544

E. Failure to resolve disputed issues of fact 547

F. Inadequate resources

V. Remedial action- 550

A. Extent of disciplinary proceeding 551

B. Use of informal sanctions 554

C. Reasons for inadequate sanctions — restrictive SRO

policies 561

D. SRO internal supervision 564

E. Restitution as a sanction

F. SRO disciplinary proceedings: a final note

VI. The need for minimum SRO compliance standards 567

Table I — Number of options related sales practice (or capital/sales practice)

examinations conducted by SROs 500

Table II — Summary of SRO examination and disciplinary action as to

firmXYZ _ 509

Table III — Summary of SRO information on selected securities salesmen 512

Table IV — Selected comparison of complaints reported to NYSE and

complaints received by two N YSE member firms in 1977 525

Table V — Summary of types of options related violations detected by
SROs in their 1977 sales practices and capital/sales practice examina-
tions of firms with options commission income in excess of S1,000,000__ 539

Table VI — Options related sales practice disciplinary actions brought by

the SROs as of March 1978 7^1

Table VII — Summary of disciplinary action by an SRO against firm ABC— _ ')'>")

Exhibits:

Options study questionnaire set to the options exchanges (App. A*).
Options study questionnaire sent to the NYSE (App. B*).
Options study questionnaire sent to the NASD (App. C*).
Summary of SRO options related examinations ancl investigations of

firm DEF for 1973-1978 (App. D) 570

Letter to Richard Tebergfrom the Self-Regulatory Conference (App.

E) ;

L itter from Van P. Carter to Gerald Folev (NASD) (Oct. 11, 1978)
(App. F) J 590

Summary of statistics relating to SRO routine sales practice examina-
tions (App. G) 004

Summary of SRO financial resources (App. H) 611

*These appendix exhibits are available publicly in the Commission's public reference room and, there-
fore, are not published as a part of this report.

XXXII

CHAPTER VII— Financial Regulation in the Options Markets:

1 Page

Introduction 615

Broker-dealer financial regulation 620

1. The Securities Investor Protection Act 620

2. Commission action 621

(a) Commission's customer protection rule 621

(b) Commission's uniform net capital rule 622

3. The Options Clearing Corporation financial rules 625

(a) OCC clearing members 625

(b) OCC member capital requirements. 628

(d) OCC settlement requirements 632

(e) OCC clearing fund 639

4. Study of the financial integrity of the options markets 640

(a) Margin and clearing fund deposits 643

(b) Market makers and market maker clearing firms 646

.">. Recommended changes to the net capital rule 649

(a) Concentrated positions 649

(b) Short positions in near or at-the-money options 652

(d) Market maker minimum net capital 657

(e) OCC members and their affiliates that are market

makers 661

(f) Immediate charges to carrying firm under the net

capital rule 663

(g) Conversion — reverse conversion positions. 665

(h) Financial requirements of upstairs dealer firms 667

Options specialist and stock credit 674

1. Specialist accounts 676

2. Good faith credit 678

3. Free-riding and bona fide hedging 680

4. Options pricing formula 684

5. Limit on stock qualifing for specialist stock credit 691

Exhibits:

1. SEC reporting forms X-17A-5 part II and part II A 693

2. Options study letter to OCC, dated May 5, 1978 and attachment. 695

3. Options study letters to AMEX, BSE, CBOE, MSE, NASD,

NYSE, PHLX, and PSE, dated June 7, June 16, and June 27,

1978 and attachments 705

4. Options study financial and operational questionnaire:

(a) Form A 763

(b) Form B 768

5. Options floor participant equity:

(a) All options exchanges 769

(b) AMEX 770

(d) MSE 772

(e) PSE 77 3

(f) PHLX — 774

6. Options floor particpiant equity requirements 775

7. Letter from the staff of the Federal Reserve Board, dated Decem-

ber 5, 1978 776

CHAPTER VIII— Issues of Structure in the Standardized Option Markets:

I . Introduction 779

II. The statutory standards 782

A. A national market system 782

1. A national market system and SEC authority.- 782

2. Objective's of a national market system 786

3. The elimination of unnecessary regulatory re-

strictions 790

4. Communication among and dissemination of in-

formation about securities markets 792

5. Multiple trading 795

B. The basic statutory goals 797

XXXIII

CHAPTER VIII— Continued page

III. Multipl ■ trading of stan lardiz ;d option- 800

A. Th • effects of multiple trading of standardized options ._ 807

1. The effects <>f multipl" trading on the quality of

market- for multiply traded option class is 809

2. Competition among market centers 824

B. Market fragmentation : 827

1. The extent of market fragmentation for multiply

traded option classes 828

2. Brokerage fiim order routing decisions in the

fragmented market environment 830

3. Market fragmentation, option pricing, and order

interaction 839

C. Conclusions 843

1. The multiple trading of standardized options and

the Exchange Act 843

2. The multiple trading experience 84G

3. Market fragmentation and the Exchange Act 849

4. Primary market designations and automated

order routing 853

"). The multiple trading of standardized options and
recent initiatives toward the development of a
national market system 864

IV. The integration of trading of options and their underlying

Securities 870

A. The general considerations 876

1. The quality of markets 877

2. The regulatory concerns 880

(a) Market information and competitive ad-

vantage 880

(b) Manipulation and other improper trad-

ing practices 885

ligations 892

(d) Market surveillance 896

3. The extent of integration 900

4. Characteiistics of the exchange 903

(a) Primary and secondary exchanges 904

(b) The marketmaking svstems 907

B. Conclusions 1 916

1. The gradual approach 916

2. Principles of general applicability and the statu-

tory standards 917

3. The principles applied 920

V. An over-the-counter market for standardized options 926

A. Standardized options and underlying securities traded

exclusively in the over-the-counter markets 930

1. The absence of real-time last sale reporting for

underlying securities traded exclusively in the
over-the-counter markets 933

2. Representative bid and ask quotations for secu-

rities traded in the over-the-counter markets, _ 938

B. Trading exchange listed options in the over-the-counter

markets 945

1. Fragmentation and internalization 946

2. Market information and competitive advantages

of over-the-counter marketmakers 948

3. Over-the-counter markets and a national market

system which would include standardized
options 951

C. The integration of trading of options and their underlying

securities in the over-the-counter markets 952

1. Market information, competitive advantage and

improper trading practices 956

2. Marketmaking obligations and commitment to

the marketplace 963

3. Market surveillance in the over-the-counter

markets 968

XXXIV

CHAPTER VIII— Continued

Page

D. Conclusions.. 972

1. Real-time last sale reporting and representative

bid and ask quotations 972

2. An over-the-counter market for options traded

on exchanges 976

3. The integration of trading of options and their

underlying securities in the over-the-counter

markets 980

VI. The New York Stock Exchange and standardized options

trading 983

A. The predominant position of the New York Stock Ex-

change in the markets for underlying securities 987

1. NYSE market share 987

2. NYSE financial resources 988

3. NYSE marketmaking resources 990

4. Additional NYSE resources 991

B. Potential NYSE predominance of the standaidized op-

tions markets. 994

1. NYSE and the primary market designation 994

2. NYSE facilities advantage 995

3. NYSE advantage with respect to combined

orders 99(3

4. NYSE financial resources 997

5. NYSE marketmaking resources and advantages- 999

6. NYSE ability to attract talent 1005

C. Conclusions 1007

1. The predominant position of the New York

Stock Exchange 1007

2. The New York Stock Exchange and the statutory

dilemma 1014

3. A cautious approach 1021

VII. A national market system for standardized options 1028

A. Options and the evolving national market system 1028

B. Options and the objectives of a national market system- 1030

C. The form of a national market system 1035

1. A comprehensive quotation system 103(>

2. Market linkage and order routing systems 1044

3. Nationwide limit order protection 104B

4. Off-board trading restrictions 1049

Table 1 — Call option classes which have been listed on two or more options

exchanges 1051

Table 2 — Summary of price continuity data for call options multiply

traded on CBOE and AMEX 1052

Table 3 — Summary bid/ask spread data for call options multiply traded

on the CBOE and AMEX 1053

Table 4 — Total contract volume for call options listed on both AMEX

and CBOE 1054

Table 5 — Summary price continuity data for call options multiply traded

on both a primary and secondary exchange 1055

Table 6 — Summary bid/ask spread data for call options multiply traded

on both a primary and Secondary exchange 1056

Table 7 A — Weekly average variation in price per transaction for DuPont
Corp. call options on AMEX for the three months prior to and following
initiation of multiple trading 1057

Table 7B- — Weekly average variation in price per transaction for DuPont
Corp. call options on CBOE for the three months following initiation
of multiple trading 1058

Table 8A — Weekly average bid/ask spread for DuPont Corp. call options
on AMEX for the three months proir to and following initiation of
multiple trading 1059

Table 8B — Weekly average bid/ask spread for DuPont Corp. call options

on CBOE for the three months following initiation of multiple trading. 10(>0

Table 9 A— Weekly average variation in price per transaction for Merrill
Lynch call options on AMEX for the three months prior to and fol-
lowing initiation of multiple trading 1061

XXXV

Table 9B — Weekly average variation in price per transaction for Merrill

Lynch call options on CBOE for the three months following initiation pa£e
of multiple trading 10G2

Table 10A — Weekly average bid/ask spread for Merrill Lynch call options
on AMEX for the 3 months prior to the following initiation of multiple
trading 1003

Table 10B — Weekly average bid/ask spread for Merrill Lynch call options

on CBOE for the 3 months following initiation of multiple trading,- _ 1064

Table 11A — Summary price continuity and bid ask spread information

organized by size of option premium for Dupont Corporation 1065

Table 11B — Summary price continuity and bid/ask spread information

organized by size of option premium from Burroughs Corporation 10*57

Table 11C — Summary pi ice continuity and bid/ask spread information
organized by size of option premium for Digital Equipment Corpora-
tion I 1069

Table 12 — Exchange market share in options listed on both a primary and
secondarv exchange for selected days from February 24, 1977 through
August 31, 1977 _* 1071

Table 13 — Exchange market share in options listed on CBOE and AMEX

for selected days from February 24, 1977 through August 31, 1977—- 1072

Table 14 — Exchange market share in options which were multiply traded

foi selected days from February 24, 1977 through August 31, 1977 1073

Table 15 — Contract volume and market share of the CBOE and AMEX

for August 1978 1074

Table 16 — CBOE monthly contract volume and market share for American
Express, Ballv Mfg., Digital Equipment and National Semiconductor
from 1/1/78 to 10/31/78 1075

Table 17 A — CBOE market share in national semiconductor 1076

Table 17B — CBOE market share in digital equipment 1077

Table 17C— CBOE market share in Bally 1078

Table 17D— CBOE market share in American Express 1079

Table 18 — Comparison of Ballv Mfg. opening prices on AMEX and CBOE,

September 1, 1978 1 1080

Table 19 — Total options revenue for secondary exchanges and percentage

of total exchange revenues 1081

Table 20 — Total options net income for secondary exchanges and pei-

centage of total exchange net income 1081

Table 21 — Total revenues derived from option transaction charges on

secondarv exchanges and percentage of total options revenues 1081

Table 22— CBOE Table A: NYSE market share 1082

Table 23 — CBOE Table B: Distribution of market in certain common

stock? selected and eligible foi exchange option trading 1083

Table 24 — CBOE Table C: comparative financial information for self-
regulatory organizations (thousands of dollars) 1084

Appendix Exhibits * :

1. Letter to George A. Fitzsimmons, Securities and Exchange Com-

mission from James E. Buck, secretary, New York Stock Ex-
change dated September 22, 1978; and Letter to George A.
Fitzsimmons, Secretary, Securities and Exchange Commission,
from James E. Buck, secretary, New York Stock Exchange,
dated November 29, 1978.

2. Letter to George A. Fitzsimmons, Secretary, Securities and Ex-

change Commission, from Joseph W. Sullivan, president,
Chicago Board Options Exchange, dated September 22, 1978.

3. Letter to George A. Fitzsimmons, Secretary, Securities and Ex-

change Commission, from Elkins Wetherill, president, Phila-
delphia Stock Exchange, dated September 25, 1978.

4. Letter to George A. Fitzsimmons, Secretary, Securities and Ex-

change Commission, from Charles J. Henry, president, Pacific
Stock Exchange, dated September 22, 1978.

5. Letter to George A. Fitzsimmons, Secretary, Securities and Ex-

change Commission, from Robert J. Birnbaum, president,
American Stock P^xchange, dated September 29, 1978.

* These Appendix Exhibits are publicly available in the Commission's Public Reference Room and.
therefore ar^ not published as a part of this report.

XXXVI

Appendix Exhibits: Continued

Letter to George A. Fitzsimmons, Secretary, Securities and Ex-
change Commission, from Gordon S. Macklin, president,
National Association of Securities Dealers, dated September 22,
1978.

Letter to Richard I. Weingarten, special counsel, Special Study
of the Options Markets, from Joseph W. Sullivan, president,
Chicago Board Options Exchange, dated October 11, 1978.

Pacific Stock Exchange Study comparing Pacific Stock Exchange
and Chicago Board Options Exchange markets in Houston Oil
and Minerals Corporation and Teledyne Corporation during
December, 1976.

CHAPTER I
INTRODUCTION

Listed options are complex securities. To those wno understand
now tney worK, they may otter an alternative to snort term stocK trading
at lower commission costs ana a smaller commitment of capital. They
also provide a means tor smiting the risK ot unfavorable short term
stocK price movements from owners ot stocK who have, but do not wish
to Dear, those risxs/ to otners who are willing to assume such risks
in anticipation ot possible rewards from favorable price movements.

aut, ootn tne purcnasing and writing (selling) of options involve
a nign degree ot financial risK. Only investors wno understand those
nsKS, and wno are able to sustain the costs and financial losses
tnat may oe associated with options trading should participate in
tne listed options marxets. Too often, puoiic investors have been
encouraged to use listed options without regard to the suitability
ot options tor their investment needs.

n. Tne Orowtn ot Listed Cptions Trading

Tne volume of trading in listed options has grown substantially since
Leoruary, 1973 when tne Camiission authorized the Chicago Board Options
Lxcnange ("CtsOL") to inaugurate sucn trading as a pilot program. 1/

1/ securities Lxcnange Act Release No. 9985 (February 1, 1973).

(1)

The CBOE's Dilot program, designed to "test the market" for listed
ootions, was initially limited to call options on only 16 underlying
stocks. As listed options gained in popularity, the options markets
exoanded sharplv over the next four years:

— The number of exchanges trading options
qrew from one, in 1973, to five in 1977
(see Figure 1) .

— By mid-1977 the number of stocks on which
call options were traded had increased
from 16 to 219, and put options had been
added for 25 of those stocks causing a
surqe in open interest and volume (see
Figure 2) .

— The volume of listed options trades, measured
by the number of shares receivable on exercise
of an options contract, expanded from the
equivalent of 2.6 percent to the NYSE's total
share volume in 1973 to almost 75 percent

of that volume during the first six months
of 1978 (see Fiqure 3).

— Premiums paid for options contracts increased
in the agqregate from .3 percent of the dollar
value of shares traded on the New York Stock
Exchange ("NYSE") in 1973 to 8.2 percent
durinq the first six months of 1978 (see
Fiqure 4) .

The addition of new optionable stocks to those already traded was one
element in the rapid expansion of listed options volume. However,
an examination of volume trends for CBOE listed calls (excluding those
also traded on other exchanges) based on when each class was intro-
duced, as shown in Figure 5, indicates that the opportunity to rapidly ex-
oand volume by adding new listings, while extremely important in the early

Figure 1
THE EXCHANGES ON WHICH LISTED OPTIONS ARE OFFERED

Trading in listed calls began on the:

April 1973
January 1975
June 1975
April 1976
Deceirber 1976

Chicago Board Options Exchange
American Stock Exchange
Philadelphia Stock Exchange
Pacific Stock Exchange
Midwest Stock Exchange

June 1977

Trading in listed puts began on all exchanges
which traded listed calls.

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years of ODtions exchange development, has now substantially diminished

for call options. The options exchanges themselves had an incentive to

list those issues which they thought would have consistently high trading

activity. The statistics show that even if no additional classes had

been listed after 1973, trading volume on the CBOE by the end of 1977

would have expanded about eight fold over 1973's total as compared to

the 16 fold growth recorded when the trading volume for the classes

listed after 1973 is included. When the volume in multiply listed call

options and puts is also included, 1977 trading volume is shown to be

22 times qr eater than volume in 1973. The criteria established by the

ootions exchanges, and approved by the Commission, for stock selection

were designed to assure that options were written only on issues of

large, well capitalized firms with a large number of shares outstanding

and substantial volume of activity. The remaining pool of eligible underlying

stocks on which call options classes could profitably be introduced under

the listing standards of the options exchanges appears to be increasingly

limited .

The addition of puts to all underlying stocks on which calls are
currently traded could be expected to increase total options volume
significantly, fere again, however, the historical record does not
suggest that volume growth from this puts trading should be as dramatic
as the volume growth was in the call market, in particular, because

"synthetic" puts are now being created to substitute for listed put options. _2/
Moreover, out options were never as popular as call options in the over-the-
counter ("OTC") options market, rarely capturing 40 percent of the total
ootions volume of OTC ootions and more often accounting for between one-fourth
and one-third of such volume.

B. Effect of Listed Options Trading on the Securities Industry

The growth of listed options trading has resulted in a substantial
increase in options-related commission revenues earned by broker-dealer
firms. Stanford Research Institute has estimated that commissions on
listed ootions received by New York Stock Exchange ("NYSE") members more
than tripled from 1973 to 1974, increasing from $12 million to $45 million. 3/
In 1975, when registered broker-dealer firms first reported their options
commission revenue separately from other commission revenues in their
reports to the Commission, 853 registered broker-dealers reported receiving
$257 million in options commissions. By 1976, listed options commissions
received by broker-dealers had increased to $367 million, accounting for
about ten percent of total commission revenues related to the securities

2/ See infra, Chapter III.

_3/ SRI International, Chapter Ten, "Options," excerpted from,
Outlook for the U.S. Securities Industry - 1981, p. 13.

business. The first year-to-year decline in options commission revenues
occurred in 1977 when those revenues fell by about 13 percent to $319
million.

The importance of listed options commissions to broker -dealers has
varied qreatly among firms as shown in Figure 6. For example, of the
1039 firms reporting options commission income in 1977 , fourteen firms
received over fifty percent of the industry's total listed options commis-
sions and 78 percent of total listed options commissions were received
bv 51 firms. On the other hand, over 75 percent of the members of
the brokerage community received less than $100,000 in listed options
commissions and 40 percent of the 1039 firms received less than $10,000
from this source.

Besides earning direct commission revenues from options trans-
actions, broker-dealer firms also earned significant revenues from
"oDt ions-related" agency transactions. These transactions occur
when a customer acouires or sells stock in connection with an options
strategy, as, for example, when a customer sells stock short to write
a covered out. Firms do not separately report the amount of options-
related aqency business they do, and, accordingly, the amount of
revenues they earn is not known .

In addition to the agency business done by broker -dealers, a sub-
stantial number of firms and individuals engage in marketmaking activities

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on the floors of the options exchanges. In 1977, 1153 dealers engaged
in such activities. As is the case concerning broker-dealer firms
doinq an aqency business, the financial benefits of options marketmaking
activities have not been evenly enjoyed among marketmaking firms.
Amonq the 1153 specialist/marketmakers, 122 reported profits of
$100,00 or more from options trading in 1977, receiving over two-thirds
of the aaqregate $54 million in gross marketmaking profits reported
bv the marketmakers whose activities were profitable. Ch the other
hand, aaqregate losses of $15.9 million were reported by 413 specialist/
marketmakers and, as shown in Figure 7, 89 percent of all specialist/
marketmakers either reported losses or showed profits of less than
$100,000. Chly 12 specialist /mar ketmaker firms reported profits of
$500,000 or more.

C. Studies of Economic Effects of Listed Options Trading

The most comprehensive review of the effect of options trading on
the underlying stock is the Robert R. Nathan Associates Inc. study concerning
the first nine months of trading on the CBOE. This study was updated by
the CBOE in July 1975 and again in February 1976. 4/ The study concluded
that options trading had little discernible effect on:

_4/ Review of Initial Trading Experience at the Chicago Board Options
Exchange, prepared for Chicago Board Options Exchange by Robert R.
Nathan Associates Inc., Washington, D. C, December 1974;

(footnote continued on next page)

FIGURE 7

BROKER-DEALERS REPORTING GAINS ( LOSSES ) FROM ;4ARKET
MAKING IN OPTIONS ON A NATIONAL SECURITIES EXCHANGE: 1977

($ In Thousands)

Firms With Losses

Firms With Gains of:

Number

413

Less than $10,000

188

10,000 - $24,999

150

25,000 - $49,999

157

50,000 - $99,999

123

100,000 - $249,999

250,000 - $499,999

500,000 - $999,999

,000,000 - and over

Total

1,153

Gains, (Losses)
($15,935)

733
2,502
5,801
8,547
13,268
9,280
5,706
8,176

38,078

40-940 O - 79 - 4

1) The liouidity or operational efficiency of the stock market;

2) Volume of tradinq relative to NYSE volume; or

3) Price chanqes or or ice performance relative to the NYSE
market as a whole.

The Nathan studv also concluded that:

1) Exercise of options during expiration week had no systematic
effect on the daily price behavior of the underlying stock;

2) No regular or consistent pattern could be found between the
daily open interest for expiring options exercisable below
or at the current stock price (in-the-money or at-the-
money options) and the price movements of the underlying
stocks ;

3) The average closing bid/ask spreads of options stocks was
somewhat narrower than the spreads of a sample of other
stoc ks ; and

4) The volatility of the price of the sixteen underlying stocks
on which options trading first started was less after options
trading beqan.

More recent studies, however, have concluded that there are important

interactions between options prices and stock prices around expiration

dates. The price effects observed are generally smaller in size than

(footnote continued)

Analysis of Volume and Price Patterns in Stocks Underlying
CBOE Options from December 30 , 1974 to April 30, 1975, Chicago
Board Options Exchange, July 1975; Analysis of Volume and Price
Patterns in Stocks Underlying CBOE Options from December 31, 1975
to January 16, 1976, Chicago Board Options Exchange, February 1976.

the transaction costs paid by the public, _5/ possibly because of the
effects of orofessional arbitrage. In addition, CBOE volatility data for
1977 and a recent independent study of volatility _6/ indicate, that
the decline in the volatility of CBOE stocks relative to the market
in 1974 was due to cyclical market movements, not options trading.
In 1977, the relative volatility in the market for stocks underlying
CBOF options was not much different from what it was at the beginning
of the 1970's.

Other analyses have attempted to determine the economic signifi-
cance of listed options trading on the raising of capital by business.

Fbr examole, a study was sponsored by the CBOE to assess the impact
of listed ootions on the market for new issues of common stocks
of sroll comDanies. That CBOE study developed statistics on the
overlaDoina involvement of investors in options and new issues of

5/ See Kooprasch, Robert W. , "The Impact of CBOE Option Exercises
Upon The Prices of the Underlying Common Shares," Ph. D. thesis,
Rensselaer Polytechnic Institute, Troy, New York, April 1977,
and Klemkosky, Robert C. , "The Impact of Option Expirations on
Stock Prices," Journal of Finanical and Quantitative Analysis,
September, 1978, pp. 514-517. Kopprasch points out that analysis
of the effect of expiration activity on stock prices is severely
handicapped by the absence of published uncovered position data.

_6/ Naidu, G.N. "The Effect of Option Trading on Variability of
Common Stock Returns," Presented at the Annual Meeting of the
Southern Finance Association, 1977. Naidu finds evidence of
increased relative volatility of CBOE stocks in the post-
CBOE period.

yfft

Studies of the econcmic efficiency of options trading have been
undertaken which conclude that listed options trading has resulted in
increased transaction efficiency of the options market. These
studies are based upon the fact that a put can be converted into a call
and vice versa and on the presumption that a parity should exist
between out and call premiums if the market is efficient. Systematic
deviations from parity of put and call prices provide opportunities
for professionals to take hedged positions which are profitable
and indicate market inefficiencies.

Fbllowing uo earlier work by Gould and Galai in CTC
ootions 10/ Klemkosky and Resnick examined data on the secu-
rities for which both puts and calls were available in the listed
market. 11/ Gould and Galai found persistent large variations in
relative out-call prices in conventional options. Klemkosky and

10/ Relying on the principle of put and call parity, Gould and Galai
analyzed 159 pairs of closely matched options from the trans-
actions recorded by an options broker. They found that the parity
model is frequently violated in that there were many instances
in which riskless conversion activities could have been profitably
undertaken. Divergences from theoretical expected values were
larae, even larger than transactions costs. Gould, J. P. and
Galai, D. , "Transactions Costs and the Relationship Between Put
and Call Prices," Journal of Financial Economics, July 1974,
po. 106, 117, 112.

11/ Klemkosky, Robert C. and Resnick, Bruce G., "Put-Call Parity

and Market Efficiency" presented to Southern Finance Association
Annual Conference, NDvember 1978, Washington, D. C. , pp. 21-22.

small companies and other comparative information on the opinions,
attitudes and activities of investors. Among the conclusions of the
OBOE study are the following:

1) The frequently expressed belief that exchange
trading of options has caused a negative impact
on the market for small new issues is based on
conjecture, mostly of an uninformed nature.

2) There was no significant evidence that exchange
trading of options has had a negative effect

on the market for small new issues. 7/

In the CBOE study, 40 percent of options buyers who invested in both
options and new issues claimed that the availability of listed options
was one of the reasons for reduced purchases of new issues. These investors
also indicated that if listed options were not available, the percentage
of their portfolio typically going to small, new equity issues would
rise from 1.3 percent to 1.7 percent. 8/ This CBOE study concentrated
on the impact of options trading as opposed to the ultimate effects
of options transactions. Tnere has been no study of the secondary
effects on the flow of funds between the options market and other
investments. 9/

!_/ Robbins, Sydney V ^ugh, Robert E., Sterling, Francis L.

and HDwe, Tnomas \ Impact of Exchange-Traded Options

on the Market for Iv ues of Common Stock of Small Companies,

Management Analysis C r, Cambridge, Massachusetts, June 1977,
pr>. 3-4.

_8/ Robbins, et al , p. A-12.

9/ As noted earlier, commissions on options transactions amounted
to about $367 million in 1976 and $319 million in 1977.

Resnick found a lower incidence of such divergences in the listed
out-call market.

D. Summary and Conclusions of the Options Study

The rapid qrowth in options volume and the appearance of abuses

resulted in the Commission initiating an investigation and study of

the standardized listed options markets on October 17, 1977. The

Commission stated its concern about:

(1) the present ability of the self -regulatory
organizations' surveillance systems to detect
and prevent fraudulent, deceptive, and manipulative
activity, both in options and in underlying secu-
rities, in a manner which is consistent with the
maintenance of fair and orderly markets and the
protection of investors and that complies with
the reauirements of the [Securities Exchange]
Act; (2) the adequacy of existing Commission and
self-requlatory organization rules to prevent
fraudulent, deceptive and manipulative acts,
practices, devices and contrivances in connection
with options trading; (3) the development of the
standardized options markets in a manner which is
consistent with the public interest in perfection
of the mechanisms of a national market system for
securities and prevention of securities trading
which adversely affects the financing of trade,
industry and transportation in interstate commerce;
and (4) the development of appropriate standards,
formulated with reference to the purposes of the
Act, by which to measure the appropriateness of
particular programs which would have the effect
of expanding or altering existing pilot options
trading programs. 12/

12/ Securities Exchange Act Release No. 14056 (October 17, 1977)
("October Release") pp. 3-4.

As a direct result of these concerns, the Special Study of the
Options Markets ("Options Study") was established to determine
whether standardized ootions tradinq is occurring in a manner . and in
an environment which is consistent with fair and orderly markets, the
public interest, the protection of investors, and other objectives
of the [Securities Exchange] Act, and to ascertain what, if any,
additional action is necessary and proper to aid in the enforcement
of the provisions of the Act and the rules thereunder to protect
investors and to insure fair dealing in the trading of standardized
options and their underlying securities.

The Options Study has addressed many of the concerns expressed
by the Commission in the October Release. The findings and conclusions
of the Options Study will be discussed in detail in the various chapters
to this report. The Ootions Study's principal conclusions and the
steDS that the Options Study recommends the brokerage community, the
self-regulatory orqanizations, and the Commission should take to improve
the regulatory framework for the listed options markets to assure
that these markets are fair and orderly are summarized below.

1. Self-Regulatory Organization Systems

a. Market Surveillance
Market surveillance is the process of detecting trading practices
that may be inconsistent with Securities Exchange Act of 1934 ("Exchange

Act"), the rules and regulations thereunder, and the rules of self-
requlatory orqanizations. Self -regulatory organizations engage in
surveillance activities because, among other reasons, the Exchange
Act assiqns them responsibility, subject to Commission oversight,
for assuring that their markets are fair, honest, and orderly
and that their members comply with the federal securities laws.

An effective market surveillance system must be able to produce
essential trading information quickly and accurately. It must be able
to identify the brokers participating in each trade, the firms clearing
the trade, the time that the trade occurred, the price to which the
parties have aqreed, the number of shares or contracts bought and sold,
and whether the trade was executed for a customer, firm, or marketmaker
account. Ultimately, the system must be able to identify, where
appropriate, the customer that effected a transaction. In addition,
the system must be able to identify bids, offers, and orders that
were present in the trading crowd to obtain a complete picture
of the trading environment at a particular time. lb the extent
that this information is readily available, the ease of performing
surveillance functions and designing surveillance programs is increased.

A surveillance system must also provide its user with a physical
record of the trading and other market activity that the system monitors.
Such a record, often referred to as an audit trail, is necessary to verify
the information that the system produces. In particular, documentary evidence

must be maintained either in or by the system if potentially improper
trading practices are to be successfully investigated and resolved.

The Options Study reviewed the techniques that the self-regulatory
orqanizations have developed to detect manipulative conduct involving
related stock and options trading, manipulative conduct that may be
effected using only options, misuse of nonpublic information in
connection with' options trading, and violations of the position and
exercise limit and restricted option rules. This review included
inspections of the options exchanges and the NYSE and an examination
of their investigative and enforcement files. The Options Study
found that while the best of the techniques that have been developed
would provide a self-requlatory organization with a general ability
to detect such trading practices, improvements must be made to
maximize the effectiveness of self-regulatory organization market
surveillance.

1) American Stock Exchange Surveillance
Information and Audit Trail

Each of the exchanges that permits the trading of standardized

options has some ability to identify the parties, reporting time, and terms

of trades that take place on their trading floor. In addition, each

of these exchanges has seme ability to obtain a physical record of those

trades. The extent of these abilities, however, varies significantly.

The CBOE, Pacific Stock Exchange ("PSE"), Midwest Stock Exchange
("MSE"), and Philadelphia Stock Exchange ("PHLX") can identify the buying
and selling brokers, the firms that will clear the trade, the time that
the transaction was entered into the price reporting system, the price,
the number of contracts for each trade, and whether the trade was reported
as executed for a customer, firm or market maker account. This informa-
tion is available on an automated basis the day after the trades
occur. It is customarily obtained from order tickets or transaction
reporting slips that these exchanges collect when trades are executed
and is key ounched into exchange computers from the trading floor.
The order and transaction reporting tickets are kept in case they
are needed for surveillance purposes at some later date.

The American Stock Exchange ("AMEX") , on the other hand, does not
maintain as complete a record of each options trade that occurs on its
floor. As a result, it cannot verify trade information by using its
own records. Moreover, the AMEX cannot identify, on a regular,
automated basis, the brokers that execute each options trade or the
firms that will clear the trade. Consequently, the AMEX must resort
to the slow and costly process of manually reconstructing trading
from specialist and registered option trader ("ROT") reports and from
order tickets obtained from member firms to detect and investigate
Questionable trading practices that may take place on its floor.
The need to use manual processes to reconstruct options trading

makes this reconstruction at best costly and time consuming, and at
worst impossible, for the AMEX to perform many of the surveillance
procedures that other options exchanges perform routinely.

The AMEX has recoqnized that its surveillance system does not
routinely provide information that is essential to an effective
detection program. It has also recognized that a computer could
oerform more efficiently and more completely many of the functions
that the exchange now performs manually. As a result, the AMEX has
undertaken to improve the surveillance information that the exchange
reaularlv obtains. Specifically, the AMEX intends to establish
svstems that would allow the exchange to identify the parties, terms,
and reoortinq time for each trade, and would provide a physical
record, or "audit trail," of the trade for investigation and verifica-
tion purposes. The exchange has represented that it will seek to
implement this system during the first quarter of 1979, and began a
"pilot test" of this new system on October 2, 1978.

Accordinqly, the Options Study recommends:

THE AMEX SHOULD ESTABLISH A COMPLETE AUDIT TRAIL
FOR EACH OPTIONS TRANSACTION THAT TAKES PLACE ON
THE AMEX FLOOR IN ACCORDANCE WITH THE SCHEDULE
THAT THE EXCHANGE PRESENTED. THE COMMISSION
SHOULD REQUIRE THAT THE AMEX SUBMIT A COMPLETE
REPORT ON THE RESULTS OF ITS "PILOT TEST" AS
SOON AS THEY ARE AVAILABLE. THE DIVISION OF
MARKET REGULATION SHOULD FOLLOW THE PROGRESS
OF THE AMEX CLOSELY TO ASSURE THAT THE EXCHANGE
ENHANCES THE CAPABILITIES OF ITS SURVEILLANCE
SYSTEMS AND ESTABLISHES A PROPER AUDIT TRAIL
AS QUICKLY AS POSSIBLE.

2) New York Stock Exchange Surveillance Information
and Audit Trail

The NYSE does not have the ability to identify, on a routine,

automated basis, the participants in each stock trade on its floor.

Nor does the NYSE maintain a record, collected at the time that orders
are executed, which indicates the parties, the reporting time, and
the terms of each NYSE stock trade. While the Options Study has
not examined or analyzed the NYSE stock surveillance system as
a whole, the lack of such essential surveillance information raises
a substantial concern reqarding whether the exchange has the ability
to fulfill its statutory responsibilities on a daily basis for each
stock that is traded on the NYSE floor, including those on which options
are traded. Moreover, despite the NYSE's recent initiation of a multi-
million dollar "trading facilities upgrade project," the exchange
has not yet committed itself to obtain regularly the surveillance
information that it lacks. 13/

Accordingly, the Options Study recommends:

THE COMMISSION SHOULD CONDUCT A COMPLETE INSPECTION
OF THE NYSE MARKET SURVEILLANCE SYSTEM TO DETERMINE
WHETHER THE EXCHANGE HAS THE ABILITY TO CARRY OUT
THE PURPOSES OF THE ACT AND TO COMPLY, AND ENFORCE
COMPLIANCE BY ITS MEMBERS, WITH THE ACT, THE RULES
AND REGULATIONS THEREUNDER, AND NYSE RULES.

13/ Letter to Harold M. Williams, Chairman, Securities and Exchange
Commission, from William M. Batten, Chairman, New York Stock
Exchange, dated October 16, 1978.

SPECIFICALLY, THE INSPECTION SHOULD CONSIDER
WHETHER THE NYSE CAN DETECT, ON A DAILY BASIS AND
FOR EACH STOCK TRADED ON THE NYSE, TRADING
PRACTICES THAT MAY BE INCONSISTENT WITH THE
ACT, THE RULES AND REGULATIONS THEREUNDER, OR
EXCHANGE RULES. THE INSPECTION SHOULD BE
CONDUCTED AND COMPLETED AS EXPEDITIOUSLY AS
POSSIBLE AND A COMPLETE REPORT SHOULD BE
PRESENTED TO THE COMMISSION WITHIN SIXTY DAYS
AFTER THE COMPLETION OF THE REVIEW.

IN THE EVENT THAT THE INSPECTION REVEALS THAT
THE NYSE CANNOT FULFILL ITS STATUTORY RESPONSI-
BILITIES ON A DAILY BASIS, THE COMMISSION SHOULD
TAKE APPROPRIATE REMEDIAL ACTION AND SHOULD
SPECIFICALLY CONSIDER REQUIRING, BY COMMISSION
RULE, THAT THE EXCHANGE COLLECT AND MAINTAIN
ESSENTIAL SURVEILLANCE INFORMATION WITH REGARD
TO EACH NYSE TRADE.

3) Firm Proprietary and Customer Trading Information
Certain surveillance information that is essential to effective
market surveillance is not readily available to any self-regulatory
orqanization. Specifically, the stock clearing process does not
distinguish between firm proprietary and customer stock positions,
and the identity of customers who effect stock or options trades cannot
be determined using surveillance information that is easily accessible
to the self-regulatory organizations. Self-regulatory organizations
must seek this information from the firms that entered the orders on
behalf of the customers. As a result, investigations into firm
proprietary stock trading, and into customer trading generally,

require frequent, costly and time-consuming correspondence oetween
self -regulatory organizations and their member firms for the purpose
of identifying the accounts involved in trading activity.

The NYSE and the Securities Industry Automation Corporation ("SIAC"),
however, have initiated studies to determine the cost and feasibility
of distinguishing between firm proprietary and customer trading, and of
ootaining customer account identification information in the stock
clearing process. Tney have represented that these studies will be
completed oy March 31, 1979. 14/

Accordingly, the Options Study recommends:

THE COMMISSION SHOULD REVIEW THE SIAC REPORT
CONCERNING FIRM PROPRIETARY AND CUSTOMER TRAD-
ING AS SOON AS IT IS COMPLETED. THE SELF-
REGULATORY ORGANIZATIONS AND THEIR MEMBER FIRMS
SHOULD WORK TO ESTABLISH AN ECONOMICAL METHOD
FOR IDENTIFYING AND DISTINGUISHING MEMBER E I
PROPRIETARY AND CUSTOMER STOCK ORDERS AND
TRANSACTIONS. IN THE EVENT THAT THE SELF-REGULATORY
ORGANIZATIONS DO NOT DEVISE A METHOD FOR EASILY
IDENTIFYING MEMBER FIRM PROPRIETARY AND CUSTOMER
TRADING, THE COMMISSION SHOULD CONSIDER WHETHER
IT IS APPROPRIATE TO REQUIRE THAT THEY DO SO BY
COMMISSION RULE.

IN ADDITION, THE COMMISSION SHOULD BEGIN TO STUDY
THE MOST APPROPRIATE MEANS OF ESTABLISHING A
UNIFORM METHOD OF IDENTIFYING STOCK AND OPTION
CUSTOMERS ON A ROUTINE, AUTOMATED BASIS. THE
COMMISSION SHOULD REVIEW THE NYSE AND SIAC REPORT
ON THIS SUBJECT AND SHOULD DETERMINE THE STEPS
THAT SHOULD BE TAKEN TO ESTABLISH A UNIFORM
ACCOUNT IDENTIFICATION SYSTEM IN LIGHT OF THE REPORT.

4) Options Clearing Corporation Position Adjustments
The Options Study has found that surveillance information currently
available from the Options Clearing Corporation ("CCC") may be inadequate
to detect abuses in the position adjustment process. Position adjustments
mav be used to accomplish improper purposes such as trade reversals,
ooeninq transactions by customers or firms in restricted options, and
the avoidance of public priority rules for limit orders and off-floor
tradinq. But clearing firms may submit position adjustments to the

14/ Letter to Richard Teberg, Director, Special Study of the Options
Markets, from Robert M. Bishop, Senior Vice-President, New York
Stock Exchange, dated September 28, 1978

OCC for several legitimate reasons: To correct errors and omissions

that mav occur when the teens and parties to an options trade are

entered into the computers of the firms for clearing purposes; to

transfer accounts between two clearing firms; or to adjust records

when one clearing firm executes and compares trades for another firm

on an options exchange of which the second firm is not a member.

the OCC has* undertaken to improve the surveillance information

that is available with respect to position adjustments. By the end

of the first auarter of 1979, the OCC will separately identify and

distinguish all oosition adjustments involving transfers of accounts
and adjustments that occur because a firm is not a member of the exchange

on which a transaction that the firm cleared was effected. The OCC

will also prohibit adjustments between clearing firms and will code

and identify certain types of adjustments. Tne Options Study believes

that these changes will substantially reduce the potential for abusing

the adjustment Drocess and will improve the ability of the self-

reaulatory organizations to monitor adjustments.

Accordingly, the Ootions Study recommends:

THE OCC SHOULD IMPLEMENT ITS PROPOSED REVISIONS
IN THE POSITION ADJUSTMENT PROCESS AS SCHEDULED.
THE OCC SHOULD ALSO STUDY THE FEASIBILITY OF FURTHER
REDUCING THE NUMBER OF POSITION ADJUSTMENTS BY
REQUIRING ITS MEMBERS TO RECONCILE THEIR ACCOUNTS
TO OCC RECORDS ON A DAILY BASIS AND BY IMPOSING
A SURCHARGE ON FIRMS THAT SUBMIT AN EXCESSIVE
NUMBER OF ADJUSTMENTS. THE RESULTS OF SUCH A
STUDY SHOULD BE SUBMITTED TO THE DIVISION OF
MARKET REGULATION WITHIN NINETY DAYS.

5) The Sharing of Surveillance Information

and the Allocation of Regulatory Responsibility

The Ootions Study observed a need for greater coordination of

self-reaulatory surveillance Drograms and for the sharing of

surveillance information. The Options Study has discussed these

matters with the self-regulatory organizations with a view toward

establishing a "more coherent and rational regulatory structure"

for market surveillance. 15/ During August and September 1978,

15/ S. Reo. No. 94-75, 94th Cong., 1st Sess. 2 (1975).

reoresentatives of the options exchanges, the NYSE, the National

Association of Securities Dealers ("NASD"), the OCC, and the Boston

Stock Exchange (collectively the "Self-Regulatory Conference" or

the "Conference") met to discuss the —

need for the creation of an integrated
requlatory system among the [self -regulatory
organizations] which would enhance total
industry regulatory capability by coordinating
and interfacing existing regulatory data and
programs through the sharing of available
information, improvement of regulatory
techniaues, [and] the allocation of regula-
tory responsibility. . . . 16/

The members of the Conference "acknowledge that the establishment of

a more fully integrated regulatory system is both necessary and desirable

as a means of establishinq more efficient and effective regulation

which mav be cost-effective to the industry and achieve minimum standards

of regulation on an industry wide basis thus assuring the protection of

oublic investors." 17/

Durinq their working sessions, the members of the Self-Regulatory

Conference identified all market surveillance reports and information

oresently available and reached a "consensus that the sharing of data

16/ Letter to Richard Teberg, Director, Special Study of the Options
Markets, from the Self -Regulatory Conference, dated October 6,
1978, at p. 2.

17/ Id., at p. 3.

... is both needed and desired." 18/ They specified the surveillance
information that they would like to receive from each other on a routine,
automated basis and agreed generally to share all surveillance informa-
tion. In addition, they agreed to consider principles for allocating
surveillance responsibilities among themselves and agreed to continue
their meetinas to implement their information sharing plans and "to
allocate additional responsibilities with respect to matters arising
from inter-market regulatory problems and to further eliminate regulatory
duplication." 19/ They also invited the Commission to send a representative
to future meetings. The Options Study believes that implementation
of the initiatives that the Conference has taken is necessary to assure
that self-requlatory surveillance programs are maximally effective.
Accordinqly, the Options Study recommends:

THE COMMISSION SHOULD CLOSELY MONITOR THE EFFORTS
OF THE SELF-REGULATORY ORGANIZATIONS TO SHARE
SURVEILLANCE INFORMATION AND COORDINATE SELF-
REGULATORY ACTIVITIES. THE COMMISSION SHOULD
ACKNOWLEDGE BY LETTER THE FORMATION OF THE
CONFERENCE AND SUGGEST THAT THE USE OF SECTION
17(d)(2) OF THE ACT AND RULE 17d-2 THEREUNDER
TO ALLOCATE SURVEILLANCE RESPONSIBILITIES AMONG
THE SELF-REGULATORY ORGANIZATIONS IS APPROPRIATE
AND DESIRABLE. IN ADDITION, THE COMMISSION SHOULD
SEND A REPRESENTATIVE TO FUTURE MEETINGS OF THE
CONFERENCE. THE COMMISSION SHOULD ALSO SEEK TO
COORDINATE ITS OWN SURVEILLANCE OPERATIONS WITH
THOSE OF THE SELF -REGULATORY ORGANIZATIONS.

18/ Id., at p. 4.
19/ Id., at p. 12.

40-940 O - 79 - 5

6 ) Investigation and Enforcement

The detection of trading that may be inconsistent with the federal
securities laws cannot, however, be the end of surveillance. When
such trading is detected, it must be investigated to determine whether
the Exchange Act or self-regulatory organization rules have been violated,
Moreover, where violative conduct is found, the federal securities laws
and self-regulatory organization rules must be enforced and the conduct
sanctioned with a view toward punishing the violator and deterring
future violations. The Options Study's inspections of the options
exchanges revealed significant differences in the thoroughness and
effectiveness of their investigation and enforcement programs.

Generallv, CBOE and PSE investigations were complete and adequately
documented. At the FHLX, on the other hand, the extent of investigatory
and enforcement efforts was difficult to evaluate because much of the
investigatory process was informal and undocumented.

Accordingly, the Options Study recommends:

THE PHLX SHOULD PROVIDE COMPLETE DOCUMENTATION
WITH RESPECT TO ROUTINE SURVEILLANCE FUNCTIONS AND
INVESTIGATIONS THAT THAT EXCHANGE PERFORMS. SUCH
DOCUMENTATION IS NECESSARY TO ASSURE THAT THE PHLX
IS CARRYING OUT ITS STATUTORY RESPONSIBILITIES
PROPERLY.

The Options Study's inspection of the AMEX revealed that trading
practices that may have been inconsistent with the Exchange Act or
AMEX rules were often detected and investigated. Subsequently, however,
the AMEX staff closed many cases with no action even though the
circumstances suggested that a violation may have occurred. The Options
Studv found the AMEX case closing procedures troublesome because AMEX
cases were seldom formally prepared and, perhaps as a result, factual
and legal argument and analysis were not as precise or thorough as
the Exchange Act reouires. In addition, the AMEX staff often closed
cases because it was of the view that a panel of AMEX members would
not impose disciplinary sanctions under the circumstances of the case.
As a result, the AMEX staff is effectively able to set the legal
and ethical standards for trading conduct on the AMEX floor with
no involvement of the AMEX membership. Recently, however, the AMEX
undertook to form a special committee of its Board of Governors,
to review, among other things, all investigative and enforcement
activities of the staff.

Accordingly, the Options Study recommends:

THE AMEX SHOULD FORM A SPECIAL COMMITTEE OF

ITS BOARD OF GOVERNORS THAT WILL REVIEW THE

INVESTIGATION AND ENFORCEMENT ACTIVITIES OF

THE EXCHANGE. THE COMMITTEE SHOULD BE COMPOSED,

AS THE AMEX SUGGESTED, OF FLOOR AND NONFLOOR

MEMBERS, EXCHANGE OFFICIALS AND A REPRESENTATIVE

OF THE PUBLIC. IN ADDITION TO ITS GENERAL REVIEW,

THE COMMITTEE SHOULD SPECIFICALLY EXAMINE, AT
IEAST EVERY SIX MONTHS, EVERY INVESTIGATIVE FILE
IN WHICH THE INVESTIGATIVE AND ENFORCEMENT
ACTIVITIES OF THE STAFF HAVE BEEN COMPLETED.
THE FILE SHOULD IDENTIFY THE REASONS THAT THE
INVESTIGATION WAS INITIATED, THE STEPS THAT
WERE TAKEN TO INVESTIGATE THE MATTER, THE CON-
CLUSIONS THAT WERE REACHED CONCERNING EACH
ASPECT OF THE POTENTIALLY VIOLATIVE CONDUCT,
THE RATIONALE FOR EACH CONCLUSION, AND FULL
DOCUMENTATION TO SUPPORT THE RESULT.

FURTHER, COMMISSION INSPECTIONS OF THE AMEX
SHOULD EMPHASIZE A REVIEW OF CASE FILES
THAT ARE CLOSED AFTER INVESTIGATION TO ASSURE
THAT AMEX ENFORCEMENT RESPONSIBILITIES ARE
PROPERLY CARRIED OUT.

An inspection of the MSE options surveillance program caused the
Options Study concern in two areas. First, although MSE documents
indicated the exchange had detected numerous instances of trading
that may have been inconsistent with the Exchange Act or MSE rules,
no records were maintained indicating whether any subsequent investi-
gation was done. As a consequence, it is impossible to determine
the regularity, adequacy, or extent of investigations of potential
improprieties that the MSE surveillance system detected. Second, the
case files that the Options Study reviewed demonstrated that MSE
investigations that were conducted were often incomplete and concluded
prematurely.

Accord inqlYf the Options Study recommends:

THE COMMISSION SHOULD CONDUCT A COMPLETE INVESTIGATION
OF THE MSE OPTIONS SURVEILLANCE PROGRAM. THE INSPECTION
SHOULD SEEK TO DETERMINE WHETHER THE MSE HAS THE ABILITY
TO ENFORCE COMPLIANCE WITH THE ACT AND MSE RULES WITH
RESPECT TO OPTIONS TRADING ON THE MSE FLOOR.

b. Broker-Dealer Oversight

Each of the self -regulatory organizations has monitoring, investi-
gation, examination, and disciplinary programs to assure that their broker -
dealer member firms comply with the federal securities laws and the
self-regulatory organization rules governing, among other things,
sellinq practices. The Options Study reviewed the broker-dealer
sales practice programs and investigative and enforcement files
at the options exchanges and the NYSE and conducted: interviews
with officials of self -regulatory organizations regarding the
operations of these programs. The Options Study found that broker-
dealer oversight urograms of the self-regulatory organizations
have been inadequate to assure the protection of the public.

The self-regulatory organizations, in their oversight of member
firms, fail to use public customers as a source of valuable regulatory
information and to collect relevant data from one another. Public
customers are not routinely questioned in conjunction with examinations
and investiqations of member firms and their associated persons and,

tneretore, self-regulatory oryanizations frequently terminate
investigations prematurely or tail to pursue potential violations
uncovered by routine examinations, 'mere is also no routine exchange
auong sell -regulatory oryanizations of essential compliance information,
sucn as tne results of examinations, investigations and informal
disciplinary actions. Accordingly, the self -regulatory organizations
in many instances nave an inaccurate perception of tne conduct of
tneir member firms.

riucn valuable information available from member firms is not
assembled ana evaluated by selt-regulatory associations, primarily
oecause the sell-regulators have not sought access to such data.
Moreover, userul information available from government agencies is
neitner sougnt nor used routinely.

Investigations and examinations of retail sales practices by the
seit-reyulatory organizations normally concentrate only on detecting
memoer rirm taiiures to toilow record-Keeping procedures established
oy tne rules ol tne sell-regulatory organizations governing, for example,
tne opening of accounts ana approving of transactions. Self -regulatory
examination and investigative procedures are not adequately designed
or utilized to detect substantive violations, such as use of deceptive
sales loatenals, recommendations of options transactions unsuited to the
customer, and excessive or unauthorized trading in customer accounts.

In conducting an inquiry arising out of a customer's complaint
or a notification that a registered representative's employment has
been terminated because of a possible rule violation, the self-
regulatory organizations limit their inspection to the specific,
often narrow, issues raised by the complaint or termination notice.
These inspections do not consider whether other customer accounts of the
same registered representative may have experienced problems similar
to those of the complaining customer . Nor do these inspections consider
whether possibly related rule violations may have occurred which,
for one reason or other, may not have been articulated in the customer's
complaint or in the registered representative's termination notice.
Moreover, the self-requlatory organizations are generally reluctant
to resolve factual disputes between customer and firms, even though
this task normally is necessary to determine whether misconduct has
occurred.

Disciplinary action taken by the self-regulatory organizations has
been ineffective in deterring future violations. Non-public letters
of caution or other informal sanctions are too often imposed in
cases involving serious violations or injury to public investors.
The self-regulatory organizations also allow their member firms
to commit repeated rule violations without decisive remedial
action.

Tne Options btudy discussed these and other concerns with the
sell-regulatory organizations. Tne Self -Regulatory Conference agreed
mat "it snoula oe possible to establisn some industry-wide objectives
ror tne conauct or a [broxer-deaier firm] examination so as to insure
tne protection ol investors, "avoid regulatory duplication, and
eliminate regulatory voids". The Conference also agreed to consider
establisnmy programs "to pronote a sharing of relevant information
aoout broKer-dealer compliance activities and to assist in the execution
ol complete, comprenensive and thorough examinations of such firms." 20/
lowara tnis end, the Conlerence agreed "that a [central] repository
couia oe utilized to provide each self -regulatory organization with
more intormation than is presently utilized for purposes of registration
01 personnel, customer complaints, investigations and examinations." 21/
Tnis central repository would include "at least all information
regarding [registered representative] registration and termination,
customer complaints, and tormal actions taxen oy [the self -regulatory
oryamzations J and otner regulatory bodies...." 22/ The Options
btudy believes that tnese initiatives by the Self -Regulatory Conference
are constructive and that they should be implemented as soon as possible.

20/ Id. at pp. 7-b.

21/ Id. at p. 8.
22/ Icu at p. y.

The Options Study believes that additional initiatives are necessary

to remedy the deficiencies summarized above, and to establish minimum

standards for the performance of self-regulatory enforcement programs,

and therefore recommends:

SELF-REGULATORY ORGANIZATIONS SHOULD BROADEN
THE SCOPE OF THEIR EXAMINATIONS AND INVESTIGATIONS
AND ROUTINELY QUESTION PUBLIC CUSTOMERS IN ORDER
TO RESOLVE DISPUTED ISSUES OF FACT, TO DETERMINE
WHETHER THERE MAY HAVE BEEN A VIOLATION OF THE
SECURITIES LAWS OR APPLICABLE RULES, AND TO VERIFY
INFORMATION OBTAINED FROM ANOTHER SOURCE.

SELF-REGULATORY ORGANIZATIONS SHOULD DEVELOP WAYS TO
SHARE RELEVANT COMPLIANCE INFORMATION AND MORE EFFECTIVELY
ALLOCATE RESPONSIBILITY FOR BROKER-DEALER OVERSIGHT
AMONG THEMSELVES.

SELF-REGULATORY ORGANIZATIONS SHOULD RESTRICT INFORMAL
DISCIPLINARY ACTIONS TO CASES IN WHICH PUBLIC CUSTOMERS
HAVE NOT BEEN INJURED AND IN WHICH RULE VIOLATIONS ARE
MINOR OR ISOLATED.

SELF-REGULATORY ORGANIZATIONS SHOULD AMEND THEIR RULES

TO PERMIT THEM TO ORDER RESTITUTION TO INJURED INVESTORS AS

A SANCTION IN APPROPRIATE DISCIPLINARY ACTIONS.

2. Trading Practices

To determine how market professionals use options in connection
with investment and trading strategies the Options Study interviewed
more than 100 professional stock and options traders.

In addition, the Options Study examined numerous investigative
records already established by the Commission and the self -regulatory
organizations with regard to questionable trading practices such

as trace reversals, prearranged and tictitious trades, stock/option
manipulation and rront-running of blocxs. Tne purpose of tnis eftort
was co determine wnetner certain marKet professionals have access
to non-puolic marKet information and enjoy otner competitive advantages
tnat mignt oe inconsistent witn tne federal securities laws and wnetner
Commission or sell-regulatory organization action is necessary to prevent
uianipuiative or otner improper conduct in connection witn options trading.
Tne options Study, nowever, aid not conduct independent investigations
or particular trading situations. Nor was tne Options Study aole to
review and analyze trading data or investigations that the self-
reyuiatory organizations initiated in sufficient detail to form the
oasis ror regulatory recommendations. As a result, further study will
oe required to aetermine wnetner specific trading patterns can be
identitied which snould oe tne subject of proscriptive rules and to
rormulate appropriate rules where necessary.

a. Proressional Trading
Institutional investors generally write call options to limit

tne risx associated with their stock activities through the premiums
received, otner options market professionals, however, employ

a variety ol trading strategies. These options strategies seek
to realize trading profits in diverse ways: (1) speculation that
market prices wiil move either up or down, Tx stay within a given

range; (2) purchasing oDtions at the bid price and selling at the
offer txice to profit from the spread between the quotations; (3)
trading that reduces positions to a limited or neutral risk posture
to orofit from the passage of time or from price movements in the
underlvinq stock within a predetermined range; and (4) arbitrage.

The Options Study's review did not reveal that market profes-
sionals have competitive advantages that are inconsistent with the
Fxchanae Act or the public interest. Additional information must
be gathered, however, if the Commission and the self-regulatory
organizations are to understand whether the patterns, relationships,
and effects of stock and options trading by market professionals
may be inconsistent with the public interest in a manner not currently
perceived. In particular, more information is needed regarding
Datterns of trading near expiration and stock trading activities
that might be designed to benefit unfairly pre-existing options
positions.

Accordingly, the Ootions Study recommends:

THE SELF-REGUIATORY ORGANIZATIONS SHOULD USE THE
INTEGRATED SURVEILLANCE DATA BASE THAT THEY ARE
ESTABLISHING FOR STOCK AND OPTIONS TRADING TO DETECT
UNLAWFUL TRADING ACTIVITIES AND CONDUCT APPROPRIATE
ENFORCEMENT ACTIONS AND TO IDENTIFY PATTERNS OF
STOCK AND OPTIONS TRADING THAT SHOULD BE REGULATED
OR PROHIBITED. THE COMMISSION AND THE SELF-
REGULATORY ORGANIZATIONS SHOULD WORK TOGETHER TO
ESTABLISH PRIORITIES FOR THESE STUDIES AND THE
SELF-REGULATORY ORGANIZATIONS SHOULD REGULARLY
REPORT THE RESULTS OF THE STUDIES THAT THEY CONDUCT
TO THE COMMISSION.

Accord ingly, the Options Study recommends:

THE DIVISION OF MARKET REGULATION SHOULD OBTAIN AND
REVIEW ALL INSTANCES OF OPTIONS AND STOCK TRADING WHICH
ARE OR HAVE BEEN THE SUBJECT OF INFORMAL OR FORMAL
INVESTIGATIONS BY THE SELF-REGULATORY ORGANIZATIONS.
THE DIVISION OF MARKET REGULATION SHOULD REVIEW THIS
DATA WITH A VIEW TOWARD PROPOSING ANTI -MANIPULATIVE
OPTIONS AND STOCK TRADING RULES WHERE APPROPRIATE.

b. Position Limits

Existing options exchange rules prohibit a person from holding
more than 1,000 short calls and long puts with respect to any underlying
security. Position limit rules were adopted by the options exchanges
primarily to minimize manipulative potential and to prevent the accumulation
of large options positions that, if exercised, might affect the
price of the underlying stock.

The oresent position limit rules prevent certain larger investors
(primarily institutions) from writing calls or buying puts against
more than 100,000 shares of stock. As a result, the managers of certain
large portfolios do not presently use options because writing options
up to existing position limits does not provide significant risk limiting
capabilities for such large portfolios. To the extent that large
investors own the stock underlying the options they write, they need
not purchase stock to deliver on exercise of the calls they write or
the puts they buy and, therefore, may not need to effect transactions
which will substantially affect stock prices. As a result, a significant

portion of the theory underlying the position limit rules may not be
applicable to such covered investors.

Numerous market participants, including professional traders,
institutional investors, and self -regulatory organizations, have
maintained that the position limit rules should generally be liberalized
or otherwise modified. Further, the ability of some self-regulatory
orqanizations to grant their marketmakers exceptions from these
rules, and the manner and frequency with which exceptions have been
granted, has raised concern that the rules currently have an unequal
imrBct on members of different self-regulatory organizations. It
has been suggested that either the rules be made uniform for all
market oarticipants or that the self-regulatory organizations be
permitted to liberally grant exceptions, especially in instances
where a marketmaker might otherwise violate the rule when fulfilling
his obliaation to trade with public customers.

Accordingly, the Options Study recommends:

THE DIVISION OF MARKET REGULATION SHOULD UNDERTAKE A
COMPETE REVIEW OF THE POSITION LIMIT RULES OF THE
OPTIONS EXCHANGES. THIS REVIEW SHOULD INCLUDE:
(1) THE POSSIBILITY OF ELIMINATING POSITION LIMIT
RULES, (2) THE FEASIBILITY OF RELAXING POSITION
LIMIT RULES FOR (a) ALL MARKET PARTICIPANTS, (b) FOR
ACCOUNTS WHICH HOLD FULLY PAID, FREELY TRANSFERABLE
SECURITIES OR (c) FOR "HEDGED" POSITIONS, AND (3)
WHETHER EXCEPTIONS FROM THE RULES SHOULD BE GRANTED
TO OPTIONS SPECIALISTS AND, IF SO, UNDER WHAT
CIRCUMSTANCES.

c. Claritication of Trading Rules

Following the commencement ol the Options Study, the CBOE issued
euucational circulars to its members discussing coth specific trading
activities tnat nay be considered manipulative and the misuse of market
mtormation involving those options trades wnich taKe place prior to
tne puuiic aissemination ot mtormation concerning a large stock
trade. The Options Study believes that this type of educational
circular identities and nelps to prevent improper activity, particu-
larly in tne area ot front- running.

accordingly, the Options Study recommends:

ALL SELF-REGULaTORY ORGANIZATIONS SHOULD (1) ISSUE
INTERPRETATIONS OF THEIR RULES TO MAKE CLEAR THAT FRONT-
KUNNING IS INCONSISTENT WITH JUST AND EQUITABLE PRINCIPLES
OF TRADE BY ITS MEMBERS AND, (2) TAKE PROMPT DISCIPLINARY
ACTION AGAINST THOSE MEMBERS WHO HAVE BEEN FOUND TO HAVE
ENGAGED IN FRONT-RUNNING.

Tne Commission should also take steps to clarify the law when
necessary or appropriate. In tne area ot related stock and options
trading, tor example, there nas been much debate concerning tne
types ot trading that might be considered manipulative. Wnile
tne Commission nas proceeded against intermarket manipulation in
reliance upon section 10(b) ot the Exchange Act, and Rule 10b-5
tnereunder, tne applicability of Section 9(a)(2) of the Exchange
Act to sucn activities remains unsettled.

Trie uncertainty arises because Section 9(a)(2) applies to "a
series ot transactions in any security . . . creating actual or apparent
active trading in sucn security or raising or depressing the price

of such security, for the purpose of inducing the purchase or

sale of such security by others." Neither the Commission nor

the courts has resolved the auestion of the applicability of

this section to related stock and options trading. The Options

Study believes that this issue should be resolved by making it

clear that stock transactions effected to benefit options positions

fall within the scope of Section 9.

Accordingly, the Cptions Study recommends:

THE COMMISSION SHOULD ISSUE AN INTERPRETIVE RELEASE
OR INITIATE RULEMAKING PROCEEDINGS SPECIFICALLY
TO CLARIFY THAT INTER-MARKET MANIPULATIVE TRADING
ACTIVITY INVOLVING OPTIONS AND THEIR UNDERLYING
SECURITIES MAY VIOLATE SECTION 9.

Shortly after listed option trading began, the options exchanges adopted

so-called restricted options rules which were designed to prevent

unwarranted speculation in deep out-of-the-money options. Restricted

options rules tend to limit legitimate trading activities of some

options customers. The Options Study believes that improvements in

the customer suitability and its enforcement may, at a future date,

allow the elimination of the restricted options rules. Accordingly,

the Options Study recommends :

THE DIVISION OF MARKET REGULATION SHOULD CONSIDER
THE ELIMINATION OF THE RESTRICTED OPTION RULES
AS SOON AS THE OVERALL EFFECTIVENESS OF THE OPTIONS
STUDY'S SUITABILITY RECOMMENDATIONS CAN BE EVALUATED.

3. Selling Practices
To examine the manner in which options transactions are recommended
to public customers, the Options Study reviewed public complaint

letters, retail sales practice examinations conducted by the Commission
and the self-requlatory organizations and additional data, including the
responses to a detailed questionnaire, provided by broker -dealers.
Significant problems related to options selling practices were found.
These problems included solicitation of options transactions unsuited
to the customer; excessive and unauthorized trading in customer options
accounts; inadeouately trained registered representatives and supervisors;
deceptive advertising and sales literature; and irregularities in
options exercise practices.

a. Customer Protection
Both brokerage firms and self -regulatory organizations need to
improve their procedures to prevent sales practice abuses. As a first
step, broker -dealers and the self-regulatory organizations should
take steDs to place the customer in a better position to detect sales
practice abuses in his own account. If the customer does not have
in his possession essential information about his own account in a
form he can easily understand, the customer can not detect and prevent
improper activities in which his registered representative might engage.

1) The OCC Prospectus
One of the major regulatory safeguards intended to protect options
customers from possible abuses is a prospectus required by the Securities
Act of 1933 ("Securities Act"). Tne options prospectus is published

by the Options Clearing Corporation ("OCC"), which technically is
the issuer of all listed options. Exchange rules require that
this prospectus be delivered to every customer at or prior to the
time his account is approved for options trading. The prospectus
contains 56 orinted pages describing, in considerable detail, information
about options, their risks and the mechanics of options trading.

The current options prospectus was drafted to meet the requirements
of the Commission's general registration form, Securities Pet Form
S-l. This form is used when no other specialized form has been designated.
While the OCC has gone to considerable effort to simplify the language
of the options prospectus, the Form S-l is not designed to meet the
needs of both options buyers and sellers. The Options Study has
concluded that information concerning listed options should be dis-
closed to investors in a manner readily understandable to a reader
with no financial training and that information about options and
the trading markets for options should be separated from information
about the OCC.

Compliance by the OCC with the Securities Act can be satisfied
by the filing of a special form of registration statement and
orospectus designed for OCC as the issuer of options and adopted
nursuant to the Commission's authority under the Securities Act.
This soecial form would include information relating to the OCC,
including a description of its business and financial reports.

40-940 O - 79 - 6

To provide investors with an appropriate disclosure document,
a new document prepared by OCC would be required under the Exchange
Act to be delivered at or prior to the time of an options customer
opens an account. This document, designed for persons without
financial training, would provide investors with a simple descrip-
tion of the risks and uses of put and call options. This new
document should include a glossary of terms; a description of
(i) the risks of options trading, (ii) the fundamental uses of
options trading, (iii) the terms of options, and (iv) the mechanics
of buying, wiring and exercising options; and a simplified dis-
cussion of transaction costs, margin requirements and tax consequences
of option trading.

The effect of these recommendations would be to relieve OCC
from liability under Section 11 of the SEcurities Act for disclosures
relatina to a description and uses of options and the mechanics
of the ootions trading markets, matters with respect to which OCC
has no special expertise or control. At the same time, potential
options traders would be furnished with a disclosure document de-
siqned specifically for their needs and, in particular, for the needs
of those investors with little or no financial training.

Accordingly, the Options Study recommends.

FILED UNDER TOE EXCHANGE ACT DESCRIBING OPTIONS, THEIR
RISKS, AND THE MECHANICS OF OPTIONS TRADING BE PREPARED
BY OCC AND BE DELIVERED BY BROKER-DEALERS TO EACH OPTIONS
CUSTOMER AT OR PRIOR TO THE TIME THE CUSTOMER OPENS AN
OPTIONS ACCOUNT.

2) Customer Suitability

Another safeguard designed to protect the customer from unethical
or illegal selling nractices is the brokerage firm's own evaluation of
the customer's suitability to trade in options. The self-regulatory
organizations have adopted rules establishing suitability standards
which are to be aoplied by broker-dealer firms to prevent the firms
and their registered representatives from making unsuitable recom-
mendations to customers. The suitability rules of the options exchanges,
however, do not match the suitability warning in the prospectus.

The current options prospectus states on the cover page in

bold face type :

Both the purchase and writing of Options involve
a high deqree of risk and are not suitable for many
investors. Such transactions should be entered into
only by investors who have read and understand this
prospectus and, in particular, who understand the
nature and extent of their rights and obligations
and are aware of the risks involved.

The options exchanges do not require, as does the prospectus, that

the customer understand the risks of recommended options transactions,

except when the particular recommendation is to write (sell) uncovered

calls or to write put options.

This important distinction can be seen in the general suitability

rule of the CBOE. This rule, which is similar to those of the other

options exchanges, requires only that a registered representative

who recommends options transactions to a customer:

shall have reasonable grounds for believing
that the recommendation is not unsuitable
for such customer on the basis of the
information furnished by such customer after
reasonable inauiry as to his investment
objectives, financial situation and needs,
and any other information known [to the
broker-dealer firm or registered representa-
tive] . (Emphasis added.)

Only when the registered representative's recommendation is to write

uncovered call or put options does the CBOE rule require that the

customer should understand the risks involved, thder this paragraph

of the rule, writing uncovered calls or writing puts is deemed unsuitable

unless:

upon the information furnished by the customer ,
the person making the recommendation has a
reasonable basis for believing at the time of
makinq a recommendation that the customer has
such knowledge and experience in financial
matters that he may reasonably be expected to be
capable of evaluating the risks of such transac-
tion, and such financial capability as to be
able to carry such position in the option contr ac t .
(Emphasis added.)

The Options Study believes that a customer should be made aware,
on an on-ooing basis, of the risks of any and all options transactions
undertaken by the customer and that a brokerage firm should not be per-
mitted to recommend any opening options transaction to a customer unless

the firm reasonably expects that the customer is capable of both
evaluatinq the risks and bearinq the financial burden of those risks.

lb insure that this standard is met on a continuing basis, infor-
mation concerninq a customer's current financial resources, needs,
and sophistication should be obtained by the brokerage firm. This
information should be utilized in determining the suitability of options
trading for a customer, first at the time a customer opens an account
and again before a registered representative recommends a new, more
comolex, or riskier options strategy than the type for which the
customer has already been approved.

Without accurate and complete data about a customer's financial
oosition and objectives, a brokerage firm cannot make well founded
decisions concerning the suitability of options trading for that
customer. Too often, a registered representative, without detection,
fabricates suitability information about prospective new options customers
solelv in order to secure from his supervisor the required approval
of transactions for an account. The State of Wisconsin has resolved
this oroblem by requiring that the management of a brokerage firm
send to each new optior ^er a copy of the completed suitability

information form relating chat customer. This process assures the
customer an opportunity to review the information form, outlining
his financial objectives and position, which the registered repre-
sentative has already filled out.

accordingly, tne Options Study recommends:

THE SELF-REGULATORY ORGANIZATIONS SHOULD REVISE
THE1K OPTIONS SUITABILITY RULES TO PROHIBIT
A tiROKER-DEALER PROM RECOMMENDING ANY OPENING
OPl'IONS TRANSACTIONS TO A CUSTOMER UNLESS THE FIRM HAS
A REASONABLE BASIS FOR BELIEVING THAT THE CUSTOMER
IS AbLE TO EVALUATE THE RISKS OF THE PARTICULAR
RECOMMENDED TRANSACTION AND IS FINANCIALLY ABLE
TO BEAR TBE RISKS OF THE RECOMMENDED POSITIONS.
THE BELF-REGULATORY ORGANIZATIONS SHOULD FURTHER
AMEND THEIR RULES TO REQUIRE:

— THAT CUSTOMER INFORMATION FORMS BE STANDARDIZED
AND REVISED TO INDICATE THE SOURCE OF SUITABILITY
INFORMATION ABOUT THE OPTIONS CUSTOMER;

— THAT THE MANAGEMENT OF EACH MEMBER FIRM SEND TO
EVERY NEW OPTIONS CUSTOMER FOR HIS VERIFICATION
a COPY OF THE FORM CONTAINING THE CUSTOMER'S
SUITABILITY INFORMATION AND 'THAT 'THE CURRENCY OF
INFORMATION ON SUCH FORMS BE CONFIRMED SEMI-
ANNUALLY;

— THAT MEMBER FIRMS BE PROHIBITED FROM RECOMMENDING
OPENING OPTIONS TRANSACTIONS 'TO CUSTOMERS WHO REFUSE
TO PROVIDE SUITABILITY INFORMATION, AND FOR WHOM THE
FIRMS DO NOT OTHERWISE HAVE INDEPENDENTLY VERIFIED IN-
FORMATION SUFFICIENT FOR THE SUITABILITY DETERMINATION; AND

— THAT MEMBER FIRMS ADOPT ADDITIONAL SAFEGUARDS FOR THE
PROTECTION OF EACH OPTIONS CUSTOMER IN WHOSE ACCOUNT
DISCRETION IS TO BE EXERCISED.

3) Opening Account Statements
Even it a customer is aDie to understand the risKs of his options
transactions, he may be contused by his account statement. Account
statements reflecting options transactions sent by brokerage firms
to tneir customers are frequently difficult to understand. Not only
may a customer nave aitticulty understanding the options transactions

reported in his statement, he may also have difficulty determining

whether he has earned a profit or sustained a loss. In certain

cases, even the customer's registered representative has been unable

to calculate the customer's profit or loss on the basis of the account

statement.

Moreover , most firms do not provide account statements which

state clearly the' individual conmissions charged on each transaction

or summarize the commission charges for the period covered. Nor do

these account statements show the customer the current equity in his

account after valuing all the customer's positions at current

"marked-to-market" prices, although a few firms have begun recently

to calculate this figure for their customers, lb add to these omissions,

account statements do not indicate the amount of certain other expenses.

Such information is essential for the customer when he attempts to

evaluate the financial consecuences of his options transactions.

Accordinglv, the Options Study recommends:

THE SELF -REGULATORY ORGANIZATIONS SHOULD ADOPT
RULES REQULRING THE OPTIONS CUSTOMER'S ACCOUNT
STATEMENT TO SHOW THE EQUITY IN THE CUSTOMER'S
ACCOUNT WITH ALL OPTIONS AND SECURITIES POSITIONS
MARKED-TO-MARKET AND THE YEAR TO DATE PROFIT OR
LOSS IN THE ACCOUNT CLEARLY SHOWN. THE OPTIONS
CUSTOMER'S ACCOUNT STATEMENT SHOULD ALSO SHOW
THE AMOUNT OF MARGIN LOANS OUTSTANDLNG AS WELL
AS COMMISSION CHARGES APPLICABLE TO EACH TRANS-
ACTLON AND OTHER EXPENSES PAID OR PAYABLE FOR THE
PERIOD COVERED BY THE ACCOUNT STATEMENT AND YEAR
TO DATE.

b. Responsibilities of Broker-Dealer Firms
Brokerage firms are responsible for dealing with customers in
a fair, ethical and professional manner. To fulfill these respon-
sibilities to the greatest extent practicable, the Options Study
believes that firms must:

— assure that their registered representatives are properly
trained;

— establish and implement appropriate supervisory controls over
their registered representatives, including establishing
and implementing adequate programs for reviewing customer
accounts;

— compile and maintain adequate information and records about
the sophistication, needs and resources of each customer;
and

— assure that communications with the public - through
advertising or other means - are truthful and accurate.

1) Qualification of Registered Representatives
A primary obligation of a broker-dealer firm to its customers should
be the assurance that its registered representatives - the people who
have the most freouent and significant contact with public customers
- are properly trained and understand their business and responsibilities,
Inadeouate or inconsistent professional qualification standards
adopted and applied by the self -regulatory organizations and
broker-dealers, however, permit untrained registered representatives
to recommend options transactions to customers.

Options exchange rules require that all sales personnel be "options
Qualified" before they can service customer options accounts, but these
aualifyinq standards appear to be ineffective. In the first place, the
examinations now used to qualify both new and experienced registered
representatives to sell options are of questionable utility. The qualifying
examination given to a new registered representative can be passed by him
— at which point he may begin selling stocks and options — even if
he missed every question relating to options. The options qualifying
examination, qiven to an experienced registered representative who wishes
to begin to sell options, is not administered under controlled test
conditions to assure that the person does in fact know the answers he
is giving on the examination. In addition, although options exchanges
impose minimum traininq requirements for options qualification, these
reauirements are largely unenforced. Because of these inadequacies,
many registered representatives now servicing the accounts of options
customers may lack the necessary knowledge and skill to perform their
functions professionally and to fulfill their legal obligations.

Accordingly, the Options Study recommends:

THE SELF-REGULATORY ORGANIZATIONS SHOULD ADOPT
RULES TO REQUIRE THAT: (A) THE REGISTERED
REPRESENTATIVE "OPTIONS QUALIFYING" EXAMINATIONS
SHOULD BE REVISED TO REQUIRE A THOROUGH
KNOWLEDGE OF OPTIONS AND THE OPTIONS EXCHANGE
RULES DESIGNED TO PROTECT CUSTOMERS. THESE
EXAMINATIONS SHOULD BE READMTNISTERED TO ALL
OPTIONS SALESPERSONS, AND ALL EXAMINATIONS
SHOULD BE GIVEN UNDER CONTROLLED SURROUNDINGS
BY INDEPENDENT EXAMINERS; AND (B) THE TRAINING

OF REGISTERED REPRESENTATIVES WHO RECOMMEND
OPTIONS TRANSACTIONS TO CUSTOMERS SHOULD BE
FORMALIZED TO INCLUDE A MINIMUM NUMBER OF HOURS
OF APPROVED CLASSROOM AND ON-THE-JOB INSTRUCTION.

2) Supervision of Registered Representatives
and of Customer Accounts

The oroblems caused by an untrained sales force may be exacerbated
by unoualified supervisors and by inadequate supervision. According
to the existing rules of the options exchanges, new customer accounts
must be approved for options trading by an officer of the firm
who has passed an advanced test - the registered options principal
("ROP") examination. But these same rules do not require that
each sales office be supervised by a person who is qualified as
an ROP although these sales offices may be recommending and effecting
options trades. In many firms, in fact, the supervisor of a sales
office is not so qualified. The ROP qualification examination is
deficient in that it concentrates on the mechanics of listed options
rather than the responsibilities of supervisors. Furthermore, some
ROPs have never passed a qualifying examination controlled by independent
examiners. As a consequence , the day-to-day conduct of the options
business at the branch level of many firms is supervised by individuals
who may have little, if any, understanding of options trading.

The Options Study also found substantial inadequacies in the
systems that broker-dealer firms use to oversee the activity in customer
accounts. In numerous instances, firm employees themselves have circum-

vented these systems. For example, options exchange rules require,
as a means of control, the initialing of discretionary orders
by a branch manager. This responsibility, however, is sometimes
delegated to a particular registered representative who himself
needs to be controlled. Supervisory problems can multiply when a
salesman is considered "special." For example, where a firm's computer
identifies potential problems in an account, branch managers and
other supervisors too often fail to take action because the registered
representative involved is a "big producer" of commission revenue.

Mother flaw in supervision can occur because many firms
are sometimes unable or unwilling to compile current, accurate
information about the status of their individual customer accounts.
Deprived of this information, a supervisor's ability to focus quickly
on critical problems in his own office is significantly curtailed.

Accordinglv, the Options Study recommends:

THE SELF-REGULATORY ORGANIZATIONS SHOULD ADOPT
RULES TO REQUIRE THAT: (A) THE ROP QUALIFICATION
TEST BE REVISED AND ALL ROPS BE REQUIRED TO
TAKE THE REVISED TEST UNDER CONTROLLED CONDITIONS ;
(B) THE PRINCIPAL SUPERVISOR OF ANY BRANCH OR
OTHER OFFICE ACCEPTING CUSTOMER OPTIONS TRANS-
ACTIONS SHOULD BE QUALIFIED AS AN ROP; (C) EACH
FIRM DESIGNATE A POLICY LEVEL OFFICIAL WHO,
ABSENT A CLEAR SHOWING OF COMPELLING CIRCUMSTANCES,
HAS NO SELLING FUNCTION TO OVERSEE THE FIRM'S
OPTIONS COMPLIANCE PROGRAM; (D) THE SELF -REGULATORY
ORGANIZATIONS DEVISE A UNIFORM SYSTEM OF SUPER-
VISORY PROCEDURES FOR FIRMS OFFERING OPTIONS
TO PUBLIC CUSTOMERS; (E) THE HEADQUARTERS OFFICE
OF EACH BROKER-DEALER ACCEPTING OPTIONS TRANSACTIONS
BY CUSTOMERS SHOULD BE IN A POSITION TO REVIEW
EACH CUSTOMER OPTIONS ACCOUNT ON A TIMELY BASIS
TO DETERMINE:

COW ISS IONS AS A PERCENTAGE OF
EQUITY IN A CUSTOMER'S ACCOUNT;

UNUSUAL CREDIT EXTENSIONS;

REALIZED AND UNREALIZED LOSSES IN
EXCESS OF AN ESTABLISHED PERCENTAGE
OF THE CUSTOMER'S EQUITY;

UNUSUAL RISKS OR UNUSUAL TRADING
PATTERNS IN A CUSTOMER'S ACCOUNT;

3) Recordkeeping and Communications with Customers
Additional problems in the area of customer accounts arise because
manv firms fail to maintain adequate records concerning their customers
and their communications with customers. These records should include
materials relating to: information about the customer's general back-
qround , financial needs, and investment objectives; any complaints
the customer may have expressed orally or in writing; the method of
allocating exercise notices to customers; and copies of worksheets
and Derformance reports which registered representatives send to their
customers in conjunction with options recommendations.

Customer complaints are frequently not available to the management
at a firm's headquarters because some firms keep them on file only at the
branch office which originally gave rise to the complaint. As a result,
it is difficult for the headquarters office to ascertain developing
branch office problems. On the other hand, some firms maintain customer
suitability information only at the headquarters office and do not
maintain copies at the branch office for use by local supervisors.

The Quality and accuracy of other forms of broker-dealer communica-
tions with the public often fall below acceptable standards. For example,
the Quality of options advertising and sales literature vary significantly
from firm to firm and these materials too often contain misleading
or inaccurate statements. Several options seminar scripts, prepared
bv the brokerage firms themselves, were found to be similarly
flawed .

lacking sufficient supervision, registered representatives are
often at liberty to send worksheets to their customers which detail
oromising returns on recommended options transactions. Worksheets
are freouently included as part of a promotional package, along
with performance reoorts of the particular firm's options program.
The Options Study has found that these worksheets and reports are
freauentlv inaccurate and that worksheets sometimes contain only
overly optimisl rejections of return which mislead customers.

Copies of these documents, which can be useful in detecting improper
sellinq oractices, are often not maintained for review by the firm.

Accordingly, the Cot ions Study recommends:

THE SELF-REGULATORY ORGANIZATIONS SHOULD ADOPT
RECORDKEEPING RULES WHICH REQUIRE THAT MEMBER
FIRMS: (A) KEEP COPIES OF CUSTOMER COMPLAINTS,
CUSTOMER SUITABILITY INFORMATION AND CUSTOMER
ACCOUNT STATEMENTS AT BOTH BRANCH OFFICES AND
THE HEADQUARTERS OFFICE; (E) KEEP COPIES OF ALL
WORKSHEETS, PERFORMANCE REPORTS AND OTHER COM-
MUNICATIONS BETWEEN REGISTERED REPRESENTATIVES
AND THEIR CUSTOMERS, AND IMPROVE SUPERVISION OVER
THE USE OF THESE SELLING DOCUMENTS; AND (C) KEEP
RECORDS CONCERNING RATES OF RETURN ON INVESTMENT
QUOTED TO OPTIONS CUSTOMERS AND IMPROVE SUPERVISION
OF AND DISCLOSURE CONCERNING OPTIONS PROGRAMS AND
SEMINAR PRESENTATIONS.

4) Exercise Allocations

Finally, the Options Study observed several instances of misalloca-
tion of exercise notices by broker-dealers, including situations in which
firm practices concerning customers' exercise allocations have resulted
in iniury to public customers. Some firms did not have, or could not
Drovide, records which disclosed the method by which exercise notices
were assigned. For this reason, it was sometimes impossible to
determine satisfactorily whether all firms have been following
options exchanqe rules regarding the allocation of exercise
notices. A uniform allocation system, coupled with consistent
recordkeeping reauirements, would prevent unfairness in the
allocation process and make the detection of irregularities in the
exercise oractice of broker-dealers easier.

Accordingly, the Options Study recommends:

THE SELF-REGULATORY ORGANIZATIONS SHOULD
ESTABLISH A UNIFORM EXERCISE ALLOCATION
PROCEDURE AND SHOULD REQUIRE THAT MEMBER
FIRMS KEEP RECORDS WHICH ARE ADEQUATE
TO PERMIT REVIEW OF EXERCISE ALLOCATION
PRACTICES.

4. Financial Structure

The Ootions Study examined the financial structure of the
options market to determine whether sufficient safeguards and con-
trols exist to protect the market place and, ultimately, the public
from being harmed by the financial failure of either broker -dealers

carryina public customer or other broker-dealer accounts or broker -dealers
on the floor of an exchanqe with market making responsibilities.
These safequards and controls include: (1) the Commission's net
caoital and customer protection rules; (2) the Commission's and SFO's
financial reportinq and early warning requirements; (3) the Federal
Reserve Board ("FRB") initial margin requirements and self -regulatory
maintenance margin requirements; (4) the Securities Investor Protection
Corporation ("SIPC") protections; and (5) the OCC financial requirements
and marqin requirements. After reviewing these safeguards and controls,
the Options Study has concluded that numerous steps should be taken
to make these safequards more responsive to the risks associated
with options positions without imposing substantial additional net
caoital requirements on market participants.

a. The Commission's Net Capital Rule
The Commission's net capital rule requires that broker -dealers
maintain a sufficient cushion of liquid assets to satisfy all customers'
claims. It establishes minimum net captial requirements ranging from
$2,500 to $100,000, depending on the nature of the firm's business,
with broker -dealers that carry customer accounts subject to a minimum
$25,000 requirement. In very general terms, net capital equals
net worth less (1) non-liquid assets and (2) a deduction (called
a "haircut") which reflects the general market risk for securities,
ranging from 1/8 percent for commercial paper to 30% of the market

value for common stock. This rule also contains provisions limiting

a broker-dealer 's volume of business in relationship to its net

capital. With respect to options, the net capital rule limits the

amount of business an OCC member can finance and guarantee for specialists,

competitive marketmakers or registered options traders who trade

on the floor of an options exchange ("market makers"). More specifically,

the rule limits the gross deductions for positions in marketmaker

accounts to ten times the OCC member's net capital.

1) Increase of Deductions in Computing Net Capital
Eased on computer analysis and impact studies of data requested,
the Ootions Study found that existing financial safeguards provide
sufficient capital to protect both the market and public investors
in periods of normal volume and price movements. The Options
Study is concerned, however, that these financial safeguards with
respect to OCC member clearing firms that carry the accounts of options
marketmakers may be inadequate during times of abnormal volume
and price surges. The amount of deductions currently required
in computing a clearing firm's net capital appears inadequate in
three areas: (1) deductions for options exercisable at prices
near or at the current market price of the underlying security
("near" or " at-the-money" options) which are subject to volatile
percentage price movements; (2) gross deductions for marketmaker

positions carried by a clearing tirm in relation to its net capital

to limit tne volume ot clearing Dusiness that can be done; and

(J) lacK ot deductions to recognize tne additional risks of market-

maxer accounts carried oy an OCC member clearing firm holding

in tne aggregate in excess of 10 percent of the outstanding open

interest in any one options class ("concentrated positions").

Accordingly, tne Options Study recommends:

THE COMMISSION SHOULD CONSIDER REVISING ITS
NET capital RULE TO:

— increase the deduction in computing net capital
eok neak ok at-the-money options by providing
that the deductions for short options positions
in marketmaker accounts be ecjual to the
greater of (l) 75 percent of the premium value,
(11) §75, or (hi) 5 percent of the market
value of the underlying stock reduced by

the amount by which the exercise price of the
OPTION VakIeS from the current market price
FOR THE STOCK.

— REDUCE the permissible amounts of gross deductions

TO NET CAPITAL, RESULTING FROM THE OPTIONS AND
STOCK POSITIONS CARRIED BY A CLEARING FIRM FOR
MARKETMaKERS.

— KEOUIRE AN ADDITIONAL CHARGE IN AN OCC MEMBER'S
COMPUTATION OF ITS NET CAPITAL FOR ANY NET LONG
OK NET SHORT1 OPTIONS POSITIONS IN ALL MARKET-
MAKER ACCOUNTS GUARANTEED BY THE OCC MEMBER
WHICH ARE IN EXCESS OF 10 PERCENT OF THE OPEN
INTEREST IN THE OPTIONS CLASS. THIS DEDUCTION
SHOULD BE EQUAL TO AN ADDITIONAL 50 PERCENT

OF THE CHARGE OTHERWISE REOUIRED FOR EACH
SERIES IN THAT OPTIONS CLASS.

40-940 O - 79

2) Net Capital Deductions for Marketmaker
Clearing Business"

The net capital deductions that result from transactions in market-
maker accounts carried by a clearing firm must be made on the same day
the transactions occur, although these transactions do not clear until the
next dav. Although this requirement was adopted with an understanding
that options transactions clear the next business day, it results in
a clearing firm having to maintain a net capital position in anticipation
of these charaes. Typically, the net capital deduction for other securi-
ities transactions by broker -dealers, however, is not made until the
day the transaction normally clears (settlement date). For example,
no charge is made to net capital on the purchase of stock by a broker-
dealer until settlement date, generally five business days after
the purchase. The Options Study has concluded that the clearing firms
should have until the next business day after their marketmaker charges
arise to make the required net capital deduction and, if necessary, to
out additional capital into the firm or to obtain additional capital
from their marketmakers. This change in the net capital rule would
not relieve a non-clearing marketmaker of his responsibility to have
equity in his account at the end of each day.

While this recommended change may have the effect of reducing
the amount of net capital clearing firms must maintain on a regular
basis, other recommendations of the Options Study will increase

their net capital reauirements and affect the timing of net capital

deductions to make them more sensitive to particular options risks.

Accordinqly, the Options Study recommends:

THE COMMISSION SHOULD CONSIDER REVISING ITS
NET CAPITAL RULE TO PERMIT A CLEARING FIRM
ONE BUSINESS DAY TO OBTAIN ADDITIONAL CAPITAL
OR MARKETMAKER EQUITY BEFORE MEETING THE NET
CAPITAL DEDUCTIONS ARISING OUT OF ITS MARKET-
MAKER CLEARING BUSINESS.

3) Marketmaker Minimum Net Capital

The 1975 amendments to the Exchange Act required that all
broker -dealers, includinq marketmakers not carrying public customer
accounts, be subject to financial responsibility requirements. Options
marketmakers which do not clear their own transactions and do not
carry nublic customer accounts currently are subject to financial
resoonsibility rules adooted by the options exchanges but are exempt
from the Commission's net capital rule.

In September 1977, the Commission's Division of Market Regulation
recommended to the Commission that it propose for public comment a
reauirement that these currently exempt marketmakers have a minimum equity
of $25,000. Although this proposed rule was not published for comment,
the Options Studv has since found that on March 31, 1978 (prior to
marketmaker losses during the April 1978 market surge), 498 of the
86 5 marketmakers on all options exchanges did not have $25,000
ecruity in their account. Of these, 279 had less than $5,000 equity
in their accounts.

The Ootions Study's data does not indicate that a $25,000 minimum
financial responsibility test need be required. An analysis was made
by the CBOE and Options Study staffs of data from two OCC member firms
clear inq marketmaker accounts which failed to comply with the Commission's
net capital rule for one day during the April 1978 market surge. This
analysis showed that less than 1 percent of the decline in net capital
at one firm resulted from markemakers with equity of less than $25,000
while at the second, these accounts were the cause of only 30 percent of
the OCC member's net capital decline. From this analysis it was concluded
that the difficulties encountered by the two OCC members were not caused
by marketmaker accounts which had only a small equity.

In view of the directives contained in the 1975 amendments to
the Exchanqe Act, the Options Study believes that the marketmakers
should be required to have a minimum equity similar to that required
under the net capital rule for other broker-dealers not carrying
public customer accounts, currently $5,000. The Options Study believes
this reouirement will add financial responsibility to the marketmaker
system without unnecessarily impeding entry into the business.

Accordingly, the Ootions Study recommends:

THE COMMISSION SHOULD CONSIDER REVISING ITS
NET CAPITAL RULE TO REQUIRE MARKETMAKERS THAT
DO NOT CARRY CUSTOMER ACCOUNTS OR CLEAR TRANS-
ACTIONS TO MAINTAIN A MINIMUM EQUITY OF $5,000.

4) Financial Requirements of Upstairs Dealer Firms

The financial requirements applicable to the options business

of broker-dealer firms that trade off the floor of an exchange ("upstairs

dealers") are substantially different from those established for a clearing
firm carryinq marketmaker accounts. The requirements for clearing
firms' short options positions recognize that a liquid market exists
where listed options are bought and sold at regularly quoted prices.
The parallel requirements for upstairs dealers, on the other hand,
are based on the assumption that no secondary market for the options
exists and that the options will inevitably be exercised. In addition,
the net capital rule requires upstairs dealers to treat certain options
positions separately even thouqh these options positions offset the risks
of other options positions held at the same time. This risk limiting
feature of certain options strategies, however, has been recognized
to some extent in the net capital rule for clearing firms carrying market-
maker accounts.

While the net capital approach to upstairs dealers may have
been approoriate when adopted because the development of the
listed options market was still uncertain, it places unnecessary
financial restrictions on the ability of the upstairs dealers
to participate in the listed options market today. The Options
Studv believes that the Commission's net capital rule should be
revised to take into account the marketability of listed options
and the risk limiting feature of certain options strategies in
establishing the financial requirements for upstairs dealers.
These upstairs dealers would still be subject to more stringent

financial reouirements overall than marketmakers and this revision

would not adversely impact on the protections afforded by the

net capital rule.

Accordingly, the Options Study recommends:

THE COMMISSION SHOULD CONSIDER REVISING ITS

NET CAPITAL RULE TO ESTABLISH REQUIREMENTS

FOR UPSTAIRS DEALERS THAT TAKE INTO CONSIDERATION

THE EFFECTS ON RISK OF SPREADING STRATEGIES

IN LISTED OPTIONS AND THE EXISTENCE OF A SECONDARY

MARKET IN OPTIONS.

5) Marketmakers that are OCC Members

In June 1977, the Commission's net capital rule was amended
as it applied to an OCC member which limited its business to acting
as a marketmaker for its own account and to carrying the accounts
of other marketmakers. The rule as modified permitted these firms
to apply the same limited "haircut" deductions to their options and
stock positions under the net capital rule as those required for
marketmaker accounts being cleared through an independent clearing
firm.

Prior to this amendment, such OCC members having an equity
interest in a marketmaker account were subject to the more onerous
"haircuts" applicable to upstairs dealers. The effect of the change
was substantial. For example, the net capital deduction required of
an upstairs dealer on selling an uncovered call option is 30 percent
of the value of the stock underlying the option with a minimum charge

of $250 for each options contract. If the same position is held
by a marketmaker , the deduction is 75 percent of the market value of
the ootion with a minimum charge of $75 for each options contract.

The options and stock positions of the marketmaker carried
by an independent firm are subject to arm's-length negotiated
review by that independent firm as part of the latter' s effort
to orotect its financial interest as a creditor of the market-
maker accounts it carries. This safeguard, however, is lacking
when a clearing firm is tradinq in options on the floor of an
exchange for its own account or is clearing an account in which
an affiliated person has an ownership interest.

Accordingly, the Options Study recommends:

THE COMMISSION SHOULD CONSIDER REVISING ITS
NET CAPITAL RULE SO THAT THE CAPITAL REQUIRED
FOR ALL OF THE POSITIONS IN AN ACCOUNT IN WHICH
A CLEARING FIRM, ITS OFFICERS, PARTNERS, DIRECTORS
OR EMPLOYEES MAINTAIN A FINANCIAL INTEREST ARE IN-
CREASED. THIS MAY BE ACCOMPLISHED BY REQUIRING THAT
SUCH ACCOUNTS MEET THE SAME FINANCIAL REQUIREMENTS
THAT ARE APPLICABLE TO UPSTAIRS DEALERS.

b. Options Specialist Stock Credit
Federal Reserve Board ("FRB") margin requirements effectively
limit the credit that may be extended by a clearing firm to a
marketmaker to 75 percent of the value of stock underlying options
positions, orovided that the exercise price of the option is
not more that 5 percent greater than the current market price

of the stock in the case of calls, or 5 percent less in the case

of puts ( "out-of-the-money" options). Ihe remaining 25 percent must

be deposited by the marketmaker with his clearing firm if the stock

position is carried for more than five businss days after purchase.

If an underlying stock position is sold within five days, the marketmaker,

unlike public customers, is not required to make any margin deposit

on the stock with his clearing firm. Certain marketmakers have

made a practice of selling their stock within this five-day period

and then immediately repurchasing the stock to retain their position

without the necessity of putting up a margin deposit. The Options

Study does not believe this type of activity contributes to an

orderly market or to the financial integrity of the options market.

1) Stock Hedge
Marketmakers frequently need to hedge the risks of their options
positions with stock, particularly when the market in a suitable off-
setting call or put is not sufficiently liquid or if puts are not
available. The Options Study believes that credit provisions should
be revised to permit the options marketmaker to finance his bona
fide hedging stock transactions through his clearing firm without
making a mar q in deoosit ("good faith credit basis") even if the
option is out-of-the-money. This type of financing is herein
called "Specialist Stock Credit." The amount of Specialist Stock
Credit that should be available to the marketmaker through his

clearinq firm, however, should be carefully defined to avoid
Soecialist Stock Credit being used to finance stock speculation.

Two steps need to be taken. First, Specialist Stock Credit avail-
able to the options marketmaker through his clearing firm should
be strictly limited to finance no more than that number of shares for
which any increase or decrease in the price of the underlying stock
would be offset by an equivalent or greater decrease or increase in the
market value of the hedged options position. In this way, the market-
maker will be unable to use this Specialist Stock Credit to speculate
in stocks underlying listed options because any gain or loss on the
stock most probably would be offset by the loss or gain on his
options positions.

To determine whether a stock position represents a bona fide hedge
of the risks of an options position, the ratio of expected stock to
options or ice movements can be calculated usinq a mathematical
formula based upon: (1) the current risk free interest rates (United
States qovernment securities); (2) the exercise price of the options;
(3) the market price of the stock; (4) the time to maturity of the
options; and (5) the volatility of the stock computed from past stock
or ice movements. This formula can be used to predict the number of
shares of stock necessary to offset price movements in related options
and is called an options pricing formula. Various pricing formulas
are currently used by most marketmakers, and by clearing firms granting

them credit, to determine the equivalent share risk exposure of an options,
or options and stock, position; however, a uniform rule should be adopted
for determininq the Specialist Stock Credit hedge ratio.

Any position in an underlying stock obtained or retained in a market-
maker account in excess of that necessary to hedge an options position,
or any stock oosition that did not underly a cualified options position,
should be immediately subject to full initial and maintenance margin
requirements.

A position in an underlying stock may be a bona fide hedge
at the time the stock is acquired but, due to a change in the delta
hedge ratio resulting from stock price movements, the underlying
stock position may exceed the amount permitted to be carried on a
good faith credit basis, m this event the options marketmaker
should be permitted to promptly liquidate his excess stock position
or adjust his options position to a hedge position, rather than
being required to make a margin deposit.

Accordingly, the Options Study recommends:

THE COMMISSION SHOULD CONSIDER RECOMMENDING
TO THE FRB THAT CLEARING FIRMS FOR MARKETMAKERS
BE PERMITTED TO FINANCE POSITIONS IN A STOCK
UNDERLYING A MARKETMAKER OPTIONS POSITION
ON A GOOD FAITH CREDIT BASIS PROVIDED THE
SPECIALIST MARKETMAKER' S SPECIALIST ACCOUNT
CONTAINS ONLY THOSE SHARES NECESSARY TO HEDGE AN
OPTIONS POSITION, AS DETERMINED IN ACCORDANCE
WITH AN APPROPRIATE OPTIONS PRICING FORMULA.

2) Limit on Stock Qualifying for Specialist
Stock Credit

The second step that should be taken to control Specialist
Stock Credit is to limit the Specialist Stock Credit available
throunh clear inq firms to a stock underlying a limited number
of options classes in which a marketmaker can reasonably be expected
to use his capital actively. All marketmakers are currently
subiect to the same credit rules with respect to stock underlying
any class of options listed on the exchange where they are floor
participants.

The Cot ions Study recognizes that the competitive marketmaker
system was designed to allow flexibility in order to permit competing
marketmakers to move their activities into different classes of
ootions as changing market conditions required and for that reason
the Cot ions Study is not recommending any change in the margin
rules applicable to marketmakers for options transactions.
Nevertheless, based on a review of the number of classes of options
in which the most active CBOE marketmakers had stock positions,
the Options Study has concluded that Specialist Stock Credit should
be limited to stock underlying no more than 20 classes of options
at any one time plus such additional classes of options as a market-
maker has been asked to maintain a market by exchange officials
to meet unusual options activity. This number , however , should
be periodically reviewed to assure that Specialist Stock Credit

is being used properly and that this limit does not unduly interfere

witn the market making process. The marketmaker should be required

to register in advance in those options in which he expects to

be eligible for Specialist Stock Credit except in cases of specific

exchange approval.

Accordingly, the Options Study recommends:

THE OPriONS EXCHANGES SHOULD REVISE THEIR RULES
TO RESTRICT THE ABILITY OF* MARKETMAKERS TO
OBTAIN SPECIALIST STOCK CREDIT TO STOCK
UNDERLYING NO MORE THAN 20 OPTIONS CLASSES,
WITHOUT SPECIFIC EXCHANGE APPROVAL.

5. Market Structure

The Options Study also examined some of the major issues of market
structure in the standardized options markets. These issues include (i)
the multiple trading of standardized options, (ii) the integration of trading
of standardized options and their underlying securities, (iii) whether,
and under what circumstances, standardized options should be traded in
the over-the-counter markets, (iv) whether, and under what circumstances,
the trading of standardized options should be permitted on the New York
Stock Exchange, and (v) steps that tne Commission should consider at this
time to assure that the standardized options markets evolve in a manner
that is consistent with the establishment of a national market system.

The Options Study Report discusses these issues with a view toward
developing an analytical framework within which they may be evaluated.
The Options Study does not present specific recanmendations with respect
to whether the Commission should approve or disapprove any particular
rulemaking proposal.

Chapter II

FUNDAMENTALS OF EXCHANGE TRADED OPTIONS

A. CHARACTERISTICS OF OPTIONS

1 . Conventional OTC Options Compared to Listed Options
For many years options on stocks were sold only in the over-
the-counter ("OTC") market. The terms of these options contracts
— often called conventional or OTC options — were negotiated and
entered into between the individual buyer and seller through
broker-dealers with performance guaranteed by a NYSE member
broker-dealer. Generally, the conventional OTC option remained
outstanding until expiration because the individualized nature
of the conventional OTC options contract made trading these options
costly and difficult. Conventional OTC options are still being written
but the activity in these options has substantially declined with
the introduction of listed options trading.

Listed options differ from conventional OTC options in several
important ways including: 1) a liquid secondary market exists
for the trading of listed options; 2) transaction costs associated with
listed ootions are lower than those for conventional OTC options;
and 3) up-to-date quotations and transaction prices on listed
options are obtainable, during the trading day, through quotation and
price reporting services found in brokerage firms; and closing prices
are available through newsDapers.

(73)

The exercise rights of holders of conventional OTC options are
against the particular seller of the options. To close a position
in a conventional OTC option requires that either the original parties
cancel the contract or that a buyer be found for the previously
negotiated contract, a cumbersome and costly Drocess generally
transacted through brokers over the telephone. Closing transactions
in listed options are effected on an options exchange.

The secondary market in listed options is made possible
because all listed options contracts have standardized terms and
are issued and guaranteed by one organization, the Options Clearing
Corporation ("OCC"), which stands as intermediary between options
buyers and sellers. Because options contracts with standardized
terms are readily interchangeable, these contracts usually can be
traded with ease.

Although the OCC issues each listed option contract which
is bought and sold by options participants, it does not act as
a dealer. A listed option is created when a person makes a
sale of an option contract in an opening transaction. The obligation
of the seller of a call option to deliver stock upon payment of
the exercise price runs to the OCC, and the OCC is obligated to
pay him the exercise price if the option is exercised. The buyer
of a call option is obligated to pay the OCC the exercise price
if he chooses to exercise, and the OCC is then obligated to deliver
the underlying stock.

The seller of any option is commonly referred to as the writer
of the option contract and is said to be "short" the option. The
buyer is the holder of the option and is said to be "long" the
ootion. The original purchase or sale of a contract is an "opening"
transaction, because it opens up a new long or short position.
The subsequent buying back of an identical option, or the sale of
an option being held, -is referred to as a "closing" transaction.

For every opening sale transaction in listed options there is a
ourchase transaction. If a writer of an option wishes to close out
his position without awaiting exercise or expiration, he may do so
by buying, in a closing purchase transaction, an option identical
to the one he sold. Similarly, a holder of a listed option may
close out his long position by entering a closing sale transaction.
Because the OCC stands between writers and holders of options, there
is no need for an openinq writer to sell to an opening buyer. Instead,
an ooening writer may sell to a buyer closing out a short position.
At any given time, however, the total obligations of writers of
listed options owed to OCC are equal to the total obligations
of the OCC to holders of the listed options. Data from the CBOE
shows that on a cumulative basis from the inception of options
trading on that exchange in 1973 through the expiration of CBOE's
November 1977 series, 68.1 oercent of opening purchase transactions
in calls by holders other than marketmakers were closed in the course of

trading on CBOE, 5.1 percent _1/ were exercised and 27.1 percent were
allowed to expire (see Figure 1).

2« The Options Contract

A stock option gives the holder either the right to buy or the
right to sell a specified number of shares at a specified price
("strike price") of a designated underlying stock during the life
of the option. An option giving the holder the right to buy the
underlying stock is known as a "call option," because it gives
the holder the right to call upon the person who sold the option
to deliver the designated underlying stock upon payment of the
exercise price. An option giving the holder the right to sell
the underlying stock is known as a "put option," because it gives
the holder the right to put the underlying stock to the seller
of the option, and the writer is then obligated to pay the stated
exercise price for ,the stock. The most significant terms of an
option include the number of shares receivable or deliverable
on exercise of the option, which is usually 100 shares, the expiration
date, the underlying security and the exercise price. An option
"premium" is the amount of money that an option buyer pays and
an option seller receives for an option contract.

Listed option contract prices are quoted based on 1) the under-
lying security, 2) the expiration month and 3) exercise price. For
example, an IBM Jan 280 call option refers to an option to buy 100

1/ OCC data show that most exercises are for the account of member
firms.

/ /

MODE OF LIQUIDATIONS OF LONG POSITIONS*
IN CBOE LISTED OPTIONS

1973

-1977

Percent of Open

ing Purchases

Closing
Call

Sales
Put

Exercises

Expira

ition

Maturity

Call

Put

Call

Put

Group

Series

1973

July

73.3

—

7.9

—

16.2

—

Oct.

77.4

—

6.3

—

13.7

1974

Jan.

58.2

—

3.9

—

36.0

—

Apr.

59.6

—

3.7

—

33.7

—

July

49.9

—

0.6

—

48.2

—

Oct.

52.9

—

1.0

—

45.2

—

1975

Jan.

70.0

—

3.7

—

25.6

—

Apr.

84.8

—

7.5

—

6.7

—

July

71.4

—

4.2

—

23.3

—

Aug.

41.8

—

1.1

—

58.5

—

Oct.

73.1

—

4.8

—

23.6

—

Nov.

60.4

—

5.3

—

34.6

—

1976

Jan.

75.9

—

8.3

—

16.9

—

Feb.

80.1

—

7.2

—

11.2

—

Apr.

76.4

—

4.0

—

17.5

—

May

66.8

—

4.1

30.4

July

79.9

—

6.5

—

15.1

—

Aug.

61.1

—

4.9

—

35.2

—

Oct.

67.8

—

5.1

—

28.4

—

Nov.

55.7

—

6.4

—

39.2

—

1977

Jan.

68.8

—

5.6

—

26.3

—

Feb.

60.1

—

6.1

—

34.0

—

Apr.

55.0

—

3.8

—

41.8

—

May

61.3

—

8.1

—

31.0

—

July

66.4

—

5.8

—

28.3

—

Aug.

60.9

72.3

5.9

5.5

33.1

23.6

Oct.

58.5

82.1

3.1

4.4

38.4

10.9

Nov.

61.7

75.8

6.3

5.8

32.9

18.3

Expired Series

1973-1977

68.1

80.7

5.1

4.7

27.1

12.6

Data are for public customer and firm proprietary accounts. Marketmaker opening and closing
transactions are not distinguished for reporting purposes and are therefore excluded from the
table. Because of occasional coding errors, total liquidations (closing transactions, exercises
and expirations) do not necessarily equal opening purchases.

JRCE: CBOE Market Statistics, various issues.

40-940 O - 79 - 8

shares of IBM common stock at 280 per share (or an aggregate of
$28,000 plus transaction costs) until the following January. An
IBM April 280 call option would refer to the same rights until
the following April.

The rights and obligations under an option contract end on its
expiration date. The expiration time for listed options has been
standardized by the options exchanges and is 11:59 p.m. eastern time
on the Saturday following the third Friday in the month in which the
option expires. Options, however, cannot be purchased or sold after
the conclusion of trading rotations, which commence at 3:00 p.m. eastern
time on the business day before expiration in order to permit the OCC
to handle the exercise of expiring ootions. _2/ All listed options
of the same type — that is, either puts or calls — covering the same
underlying security are called a "class of options," and all options
of the same class having the same exercise or ice and expiration
date are called a "series of options."

Each class of options fits within one of three exoiration cycles
which establish the month in which the option contract will expire.
Tne three expiration cycles are as follows:

2/ For orocedures regarding tender of exercise notices, see OCC
Prospectus (October 16, 1978) at 28-29.

Expiration Cycle
February
May
August
November

Exoiration Cycle
March

June

SeDt ember
December

New series are generally created with a new expiration month
for a nine-month life when an old series expires. Consequently,
options for only three expiration months are outstanding at any
one time. The exercise price for a new series of options is fixed
in relation to the price of the underlying security at the time the
trading in the new series begins. Exercise prices are generally, but
not always, fixed at five-point intervals if the underlying security
is trading below $50 a share, at ten-point intervals if the underlying
stock is trading between $50 and $200 a share, and 20-point intervals
if the underlying stock trades above $200 a share. Generally, when
trading is to be introduced in a new expiration month an options
exchanae selects two exercise prices surrounding the then current
market price. For example, if the underlying security trades at
27, new series would be opened at 25 and 30. Additional new
series are also usually introduced whenever the price of the stock
moves up or down to the midpoint of the next appropriate 5, 10,
or 20-point interval from the exercise prices of existing contracts.

For example, the price of Bally Manufacturing Corporation stock,
which is listed on the NYSE, had traded between January and September 20

1978, at highly fluctuating prices ranging from a low of 15
per share to a high of 71-3/4 per share and closed, on September
20, 1978, at 40-3/8. On September 21, 1978, the Wall Street Journal
reported the following prices of Bally options on the CBOE. Due
to the stock's great price volatility during the year, new options
series were frequently added. Such fluctuations in the prices of
stocks underlying options, however, are rare occurences.

Bally Option Prices on CBOE on September 20, 1978
- Nov. - - Dec. - - May

Option Price

Vol.

Cost

Vol.

Cost

Vol.

Cost

Bally

..15

38-1/4

47-3/8

Bally

..20

33-1/4

47-3/8

Bally

..25

28-3/4

47-3/8

Bally

..30

47-3/8

Bally

..35

116

47-3/8

Bally

..40

193

11-1/8

20-1/4

47-3/8

Bally

..45

283

9-1/4

9-1/2

122

47-3/8

Bally

..50

1411

6-1/2

131

6-1/2

156

11-1/2

47-3/8

Bally

..60

2113

3-7/8

241

6-1/2

207

8-1/4

47-3/8

Bally

..65

3021

1-5/8

490

4-1/8

225

5-3/4

47-3/8

Price refers to the exercise price of the option.

Volume refers to the number of contracts traded on
September 20, 1978 in the particular option.

Cost refers to the premium or purchase price at which
an option traded on the CBOE on September 20, 1978
divided by the - of shares the option represented.

Close refers to closing price for Bally Manufacturing
stock on the NYSE c September 20, 1978.

a. - indicates the ootion was not traded on September 20,

1978

b. - indicates no option was offered.

3 . Stock Price Considerations in Listed Options

Options can be used as a substitute for short-term
stock trading and as a means of transferring certain of the risks and
potential rewards of short-term stock price movements from the options
seller to the options buyer. Various strategies can be used to accomplish
this:

An investor who believes a stock will increase in or ice can (1) buy
the stock; (2) buy a call; or (3) sell a put. An investor who believes
a stock will decrease in price can (1) sell stock short; (2) sell a
call; or (3) buy a put.

The buyer of stock benefits from any increase in price in excess
of his transactions costs and bears the full risk of loss in the event
of a market decline. Transaction costs include commission charges and
any interest that must be paid if stock is ourchased on margin. While
a call option buyer and a out option seller benefit from a stock price
increase, their risk and reward positions are different.

The call option buyer:

. Has the right to buy the underlying stock;

Does not profit until the price of the underlying
stock increases sufficiently to cover the premium
for the call option plus transaction costs;

Limits his risk of loss to premiums paid plus
transaction costs.

The put option seller:

Has the obligation to buy the underlying security
on exercise of the option

Limits his profit to the premium received on the
sale of the option, less transactions costs;

. Limits his risk of loss only to the extent of the
market price decline of the underlying security
during the life of the option, a portion of which
would be offset by the premiums received less trans-
action costs ('net premiums").

Similarly, the risk-reward positions of a call option seller and a

out option buyer are different in the event of a stock price decline.

The call option seller:

Has the obligation to deliver the underlying stock
on exercise of the option;

Limits his profit to the Dremium received on
sale of the options, less transaction costs;

Limits his risk of loss only to the extent that
the market price increase of the underlying
security during the life of the option is off-
set by the net premium received.

The put option buyer:

Has the right to deliver the underlying stock;

. Has profits only to the extent the price of
the underlying stock declines in an amount
greater than the premium for the out option
Plus transaction costs;

. Limits his risk of loss to the premium
paid plus transaction costs.

4 . Short-Term Character of Options Trading

Although listed options may have a maximum term of nine months,
most options are written for shorter terms. Indeed, the very short-
term horizon of ootion traders is evident from the distribution of out-
standing options — called open interest — and contract volume by

expiration month. Statistics for 1977 indicate that 50 to 60 percent
of open positions are in options with less than 3 months to expiration;
over 70 percent with less than 4 months and 90 percent with less than
6 months (see Figure 2). Similarly, over 60 percent of contract volume
usually appears to be in options with less than 4 months to expiration (see
Figure 3). Even greater concentration of interest and volume exists
for some individual classes of options. For example, data for Eastman
Kodak show that nearly 70 percent of May, 1978 volume in Eastman Kodak
options was in contracts expiring in June, 1978.

FIGURE 2

PERCENTAGE OF OPEN INTEREST IN EXCHANGE TRADED CALL OPTIONS
BY MONTHS TO EXPIRATION

1977

Months to Expiration
Less Than

3 Months 4 Months 5 Months 6 Months 7 Months 8 Months 9 Months

(Cumulative Percent)

Jan.

60.0

75.3

75.6

92.2

98.2

98.3

100.0

Feb.

62.0

62.4

83.6

92.6

92.8

99.1

100.0

Mar.

53.7

76.1

86.1

86.3

96.6

99.9

100.0

Apr.

56.7

71.0

71.4

90.0

96.9

97.1

100.0

May

56.9

57.6

80.8

91.1

91.5

99.1

100.0

Jun.

49.2

73.9

85.3

85.8

96.8

98.9

100.0

Jul.

57.0

72.7

73.5

91.0

97.1

97.5

100.0

Aug.

60.5

61.6

83.1

92.2

92.8

99.0

100.0

Sep.

54.3

77.5

87.6

88.3

97.3

100.0

Oct.

60.0

74.5

75.5

91.9

97.7

98.0

100.0

Nov.

61.7

63.0

84.2

92.8

93.2

99.3

100.0

Dec.

56.5

79.6

88.8

89.5

97.8

99.9

100.0

SOURCE: Options Clearing Corporation

FIGURE 3

PERCENTAGE OF CONTRACT VOLUME IN EXCHANGE TRADED CALL OPTIONS
BY MONTHS TO EXPIRATION

Months to Expiration
Less Than

1977

3 Months

4 Months

5 Months

6 Months

7 Months

8 Months

9 Months

(Cumulative Percent)

Jan.

37.0

70.4

80.3

80.6

93.6

98.1

98.3

Feb.

49.2

63.5

64.0

81.8

89.5

89.7

98.8

Mar.

51.0

51.6

73.7

82.2

82.4

94.9

99.9

Apr.

31.1

64.1

73.0

73.3

90.1

96.1

96.3

May

50.6

64.4

64.9

82.6

90.3

90.6

98.9

Jun.

53.4

54.6

76.2

84.5

85.1

95.8

99.7

Jul.

32.5

67.8

77.5

78.2

92.1

96.6

97.1

Aug.

52.3

66.4

67.2

83.7

91.0

91.5

98.7

Sep.

53.0

53.9

76.8

84.6

85.2

95.8

99.9

Oct.

33.4

67.8

76.3

77.0

92.1

97.2

97.5

Nov.

55.5

68.4

69.3

86.1

92.3

92.7

99.2

Dec.

57.8

59.7

80.9

87.2

88.1

97.0

99.9

SOURCE: Options Clearing Corporation

5 . Transaction Costs

The short-term nature of most options contracts means that trans-
actions costs can have a significant effect on the profitability of
options transactions. The listed options markets have substantially
reduced the transactions costs of trading options. A study by Black and
Scholes of conventional CTC options transactions for the period 1966-1969
concluded that transactions costs effectively reduced the rate of return
of call buyers from 33.3 percent to 8.3 percent. In contrast, the rate
of return of call writers was reduced only from 8.6 percent to 6.6 percent.
On the basis of this research they anticipated that if the options markets
could be made more efficient, and less costly for call buyers, the demand
for options would probably increase. 3/

Transaction costs are now substantially less in listed options
than they had been in conventional CTC options. In addition, listed
option transaction costs, if considered without regard to transaction
costs that may be incurred as a result of stock trading that is related
to ootions tradina, are less than the charges for trading stock in shares
ecruivalent to that covered by an option contract. Although competitive
commission rates mean that transactions can be entered into at different
charges at different firms, the published commission charges of ten large
retail brokers and one representative discount broker illustrate the current
costs of options trading as compared with trading directly in the stock
(see Figure 4) .

_3/ Black, Fischer, and Scholes, Myron, "The Valuation of Options
Contracts and A Test of Market Efficiency," The Journal of
Finance, May, 1972, do. 414, 416.

CxJ

X CO

E-i Cu

< CO

s a

CO
Ed

o x

Although the commissions on oDtions transactions, as a proportion
of the amount of money involved in a transaction, are higher than
for stock, the dollar amount of commissions on an option contract for
1 call to buy 100 shares of stock is about one-third as large as the
commission on a 100 share transaction in the underlying stock. Because
most brokers have a minimum commission charge, however, a better
comparison might be 5 contracts for which the options commission
charges are roughly one-fourth the commission on a 500-share stock
transaction. 4/ Commissions, of course, would be different on options
and stock trades at different prices than those used in Figure 4,
but the dollar amount of commissions on an option will be less than
on a stock trade in an equivalent number of shares underlying the
option. Some discount brokers have advertised rates as low as $12.50
per option contract for fewer than five options, and $2.50 - $8.50
per contract for orders of five options or more; but such rates
may be set purposely low to attract customers with a large volume
of orders.

^/ Moreover, if the options expire worthless, the loss is automatic
and there is no sale commission involved, whereas a stock
commission is incurred on the sale of a stock at a loss or
profit.

Commissions ana commission equivalents (retail mark up) affect
uotn tne proritaoility ot a transaction and the incentives of broKer-
dealers and tneir reyistered representatives in recommending invest-
ments to tneir customers, as is described in more detail below in
cnapter V.

b. Options Pricing Models

as indicated above, tne options contract serves to unbundle the
risKs and potential rewards associated with short-term stock price
movements. Tne options price is the market valuation ot the oundle of
rigiits tnat are being transferred. Chief anong these is the right to
oenetit from or limit losses from short-term stock price fluctuations.
Tne perceived probability of significant stock price cnanges will
otten retlect tne past snort-term price movements of the stock.

borne stocKs trade witnin relatively narrow snort-term price ranges,
wnereas otner stocks are uore volatile. For example, the Wall Street
Journal reported on December 12, 1978, tnat for the 52 prior weeks
American Telephone and Telegrapn traded between 56-7/8 and 64-5/8 a
snare and closed on December 11, 1978 at 61 per snare. However,
Minnesota Mining and Manufacturing Company ("3M") nad traded during
tnis period between 43 ana 66 a share and closed on December 11, 1978,
at bl, It all otner factors could be held constant, the premium for
an option usually would be greater tor a stock whicn is expected to

nave volatile snore-term price movements than the premium tor an option
lor a stocK wnicn is expected to trade witnin a narrow range during 1
lite ol tne option, accordingly, tiie volatilities or AT&T and 3M may
nelp to explain why AT&T July 6U options closed on December 11, 197b,
at J- J/4 wnereas tne 3*4 Juiy bU options closed at 7-3/b. LiKewise, if all
otner lactors could be held constant, the price ot an option would decline
as tne contract approaches maturity. Thus, on December 11, 1978, the
Ji" Jan oU options closed at 3-J/b wnile tne 3il July bus closed at 7-3/b.
bimilarly , it all otner tactors could be held constant, the price ot an
option woulo increase or decrease as the price of the underlying stocK
riuctuates around tne option exercise price. The amount of the increase
or decrease, it any, would ot course depend upon the perceived probability
tuat tne stocK would trade at an advantageous price in relation to tne
exercise price at expiration. For example, it a call option had an exercise
^rice ot ^ju witn one weeK lert to expiration, a movement in the price
ot tne stocK trom 4U to 41 would probably have no effect on the price
ot tne option.

ut course, all lactors cannot be neld constant, and the prices
or options reflect tne complex interrelation of ail of the above
ractors as well as additional tactors tnat apply in a free market
wnicn reiiects tne judgments ot tne various participants. Neverthe-
less, many professional traders and arbitrageurs with low or no trans-
actions costs nave developed options pricing models based upon these basic

principles and upon other factors which they deemed relevant. This is
done in an attempt to identify options which appear to be under or over-
valued in relation to other options and to the stocks, in anticipation
that they will profit if these pricing discrepancies disappear and to
prevent paying prices that are too high or accepting prices that are too
low. Computers are normally used because of the multiplicity of relevant
factors, many of them generated by constantly changing conditions in the
securities markets.

The most widely known options pricing model is the theoretical valuation
formula developed by Fischer Black and Myron Scholes from which most current
options pricing models have been derived. The Black-Scholes formula was
developed from the principle that options can be used to eliminate market
risk from a stock portfolio. This theory assumes that efficient option
pricing would result in returns on options portfolios equal to the risk-
free interest rate available on investments in U.S. government securities.
Their pricing model was developed using European options which are exercisable
only at maturity and has been revised, in part, because it assumed factors
which are not characteristic of listed options, including (1) no transactions
costs; (2) no dividends; (3) the option would be exercised on only the
final day before its expiration; (4) there were no restrictions on short
selling; and (5) various assumptions about the characteristics of stock

price movements . 5/ Nonetheless tne Black-Scholes options pricing model
serves to illustrate now options pricing models work..

Tne blacx-bcnoies mathematical options pricing model requires five
items ol information to compute an estimate of an option's theoretical
value at any point in time: (1) stock price; (2) time to maturity;
(j) exercise price; (4) risK free interest rate; and (5) probable volatility
or tne stocK. 6/ All tnese factors, except volatility, are readily
aetenitinaoie as of a particular point in time. In most computer pricing
moaeis tne luture volatility of tne stocK is estimated based on its past
volatility.

Tne blacK-bcholes or similar options pricing models are also used
to estimate tne dollar-tor-dollar sensitivity of an option's price to
movements or tne price in the underlying security at any point in time.
Pricing models noid constant tne factors other than stock price that affect
tne value of an option while estimating the relationship of changes in
tne price or tiie option relative to changes in the price of the stock.
Tnis estimate of the ratio relationship between the dollar change in the
^rice ol tne option and tne dollar change in tne price of the stock is
called the "delta r actor." Tne delta factor of a call option can range

V lilacK, Fischer and Scnoles, Myron, "The Pricing of Options
and Corporate Liaoilities" The Journal of Political
Economy , nay/June 1973, p. 640.

_b/ rilacK, Fischer, "Fact and Fantasy In tne Use of Options,"
Financial analyst Journal, July-August, 1975, p. 36.

40-940 ■

from 0 to plus 1.00. The delta factor of a put option ranges from 0 to
minus 1.00. If for every one point rise in the price of the equity
security the call option price rises 1/4 point, the call option has a
delta of .25 (and the put option a delta of -.75). If, for every point
rise in the stock the call option price rises 1/2, the call option has
a delta of .50 (and the put option a delta of -.50). JJ

A long call position and a short put position increase and decrease
in value with the stock. Therefore, these positions have positive delta
factors. The value of a short call position and long put position moves
in the opposite direction of the stock price. Therefore, these posi-
tions have negative delta factors, h long stock position has a delta value
of 1.00 while a short stock position has a negative delta value of 1.00.

By assigning a delta value to all stock and option positions, a
specialist /mar ketmaker on the floor of an options exchange can establish
long and short positions in various series of options of the same class
and in the underlying stock which, if his estimates of the various delta
factors are correct, can result in a position in which any increase or
decrease in value of the stock will be offset by increases or decreases
in his combined options and stock positions. If his calculations are
correct, and his positive deltas are equal to his negative deltas, his
overall oosition will be free of risk of stock price movements and his

]_/ See Black, F. and M. Scholes, "The Pricing of Options and Corporate
Liabilities, Journal of Political Economy (May/ June, 1973), po.
642ff.

portfolio is said to be in a "neutral delta position." For example, a
sale of a call option, which has a delta of .5, can be hedged by a purchase
of two call options having a delta of .25. In this case, the value of the
short option's position will decrease by $.50 for each $1 increase in
the price of the underlying stock and the two long options will increase
by $.25 each, or a total of $.50, offsetting the loss on the short option
position.

The delta factor changes as the price of the underlying security
and the other factors that determine the price of the option change.
Usually the changes will be small on a day-to-day basis. The exception
occurs during large stock price movements when, apparently, the
statistical reliability of estimates of delta becomes suspect. How-
ever, through the use of options as hedges, portfolio managers have
sought to reduce or eliminate virtually all of the market risk on their
portfolios. However, as the market risk is reduced, the theoretical
rate of return is also reduced until it approaches the risk free interest
rate, a return which can be approximated by investing directly in U.S.
government securities.

While the computer option pricing models illuminate certain of the
factors affecting the pricing of options and can aid in options trading
decisions, the chapter on Sales Practices shows how computer -gene rated
data and certain mathematical relationships have formed the background
for unethical sales practices by broker-dealers and investment advisers
and have been used to add mysticism and unnecessary complexity to options
transactions.

7. Examples of the Effect of Options Contracts
Assuming tnat there are no pricing biases or market inefficiencies
wnicn are disadvantageous to either options writers or buyers, 8/ then the
value of the bundle of risks and potential rewards being transferred under
an options contract should be approximately equal except for commissions
and other transactions costs. An example of how an options buyer and options
seller may tare during tne lite of a seven-month options contract can help
deiiDnstrate the effect of the options contract on both buyer and seller
during a period of short term price movements in a hypothetical situation,
assuming that both the buyer and seller hold the contract until expiration.
as indicated auove, nowever, nearly all options market participants close
out tneir options positions in the secondary market prior to expiration.

b/ Tnis assumption is useful for exposition purposes, but studies indi-
cate that in tne real world, pricing inefficiencies and biases do
exist, tor example, in a study of OTC options, BlacK and Scholes
round that through pricing biases wnicn favored the seller, buyers
ettectively paid all of the transactions costs necessary for mainten-
ance of tne marKet. See BlacK and Scholes, note 3, p. 12 above,
at pp. 413-417.

also, studies by Gould and Galai, and Klemkosky and Resnick suggest
tnat theoretical put and call parity is violated by systematic
divergence of put and call prices in the real world. Listed options
have reduced these divergences and usually transactions costs in and
out preclude profitable arbitrage by most public investors. While
listed options have reduced transactions costs, there is no reason
to assuiiie that bias no longer exists, especially with restrictions
on listed puts and the higher costs that are thereby imposed on
arbitrage activities. See Gould, J. P. and Galai, D. , "Transactions
Costs and Put and Call Prices," Journal of Financial Economics, (July
1974), Galai, Dan, "Tests ot Market Efficiency of the Chicago Board
Options Exchange," Journal of Business, (April 1977) and Klemkosky,
Kooert C. and Resnick, Bruce G., "Put-Call Parity and Market Efficiency"
presented to Southern Finance Association Annual Conference, November
1978, Washington, U.C.

a . Call Option

Assume, for examole , that XYZ stock is selling at $50 a share on
October 20, and that a call option on XYZ expiring in May and exercisable
at 50 trades at 6. The writer of this option will receive $600 per contract
paid by the buyer before any allowance for transaction costs. Of course,
both sides in this transaction would have to pay commissions. If the writer
owns the 100 shares of XYZ (a covered option), he will be in a better
position than he would have been without the combined stock/option position
anytime the stock trades at less than 56 but above 44 per share, after
allowance for transaction costs (see Figure 5). The writer of the call
option, however, may be called upon to deliver the shares anytime, although
exercise is likely only when the stock price is above $50. If the writer
of the option does not own the underlying stock (an nncovered option)
or an offsetting option, the writer assumes the risks of rises in the
market price of the underlying stock and will be required to acquire and
deliver the underlying stock, much like a short-seller, if the option
is exercised against him. In exchange for the options premium, however,
the writer of the option gives up to the option buyer the right to gains
through exercise or resale of the contract. This would normally only occur
if XYZ sells above $50 a share. The covered writer retains the risks of
ownership if XYZ declines in Drice. The uncovered writer is exposed to
unlimited risks on the upside, but none on the downside.

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The buyer of this same call option will be ahead if the price of
XYZ _rises above 56 per share sufficiently to cover the costs of exercise,
his premium and transaction costs (exercise price $50, plus premium $6
plus transaction costs). The call option buyer's total outlay and
potential loss is limited to the premium plus commissions, whereas his
outlay, for 100 shares of stock, would have been $5,000, plus commissions
and he would bear the full risk of a market decline. If the stock price
does not change from $50 Der share, however, the call option buyer's
option would exoire worthless and his whole investment would be lost.
A stock investor, on the other hand, is not likely to lose all of
his investment because of the high quality stocks underlying options
and his ability to sell the stock at any time.

Because of the secondary market, either the buyer or the seller or
both can close out the ootion position at any point until expiration by
resale or reDurchase at whatever the value of the option appears to be
at that time. Thus, loss of premium can be reduced or profits realized
through closing transactions in the secondary market.

b. Put Option

The writer of a put is obligated to buy stock, at any time during
the life of the put, at the exercise price, upon delivery by the put holder
of the underlying shares. For the writer of an XYZ May 50 put to protect
himself from assuming the risk of a drop in the stock's price, he could
sell XYZ shares short, say at $50 a share. A premium of $500, received
by the out writer who has an equivalent short position in the stock, would
place him ahead if the price of XYZ rises no higher than $55 per share

100

(less transactions costs) or declines to no less than $45 per share (plus
transactions costs during the life of the option (see Figure 6). If XYZ
sells below 50 per share, the put writer may be called upon to buy XYZ
stock at 50 per share. If that happens, he will lose the benefit of part
or all of the premium depending upon how far the market is below $50 per
share. The put buyer will continue to recover portions of his premium
until the stock sells below 45 (plus an amount sufficient to pay trans-
action costs) at which point he would have recovered the premium from
the put purchase and entered his gross profit region. If the put buyer
also owns XYZ stock at the time of the purchase of the put option, he
has what is referred to as a "protective" put and he will assure himself
of a gross sale price of $50, net $45 ($50 less his premium) in the event
of a price decline. Again, of course, no allowance has been made for commis-
sion costs. By paying the premium, however, the put buyer would have
indicated his willingness to accept a net price of $45 a share and to
give up the benefits of small gains (i.e. , gains up to $5 plus trans-
action costs) for protection against a large loss ( i.e. , declines
exceeding $5 plus transaction costs) if the stock price declines.

The listed puts could be liquidated at any time in the secondary
trading market, recovering part or all of the premium value and
taking losses or profits.

101

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102

c . Gains or Losses to Options Buyers are Offset by
Losses or Gains to Options Sellers

The above diagrams show how the options buyer and seller each may
fare as the stock price moves up and down during the life of the option.
The manner in which any gain or loss realized by the options seller is
offset by an equivalent gain or loss for the options buyer (exclusive
of transactions costs) can be illustrated by simple diagrams showing the
areas of potential loss and profit of buyers and sellers of options con-
tracts in circumstances where the writer is uncovered (see Figures 7 and
8). These illustrations assume that there are no pricing biases or market
inefficiencies which are disadvantageous to buyers relative to sellers
and vice versa.

Option premiums reflect the risks being assumed by the writer or
alternatively the costs of reinsuring against those risks through
covering hedging transactions. They also reflect the option buyer's
perception of the value to him of the potential benefits from
expected price movements in the underlying stock as well as the
avoidance of the usual costs associated with taking positions in the
underlying security. Because of the general equivalence of the costs
of alternative positions in puts and calls and of the probabilities
associated with short-run upward and downward price movements in under-
lying securities, the risks in writing and the potential returns in buying
a call and a put tend to approximate each other. The interrelationship
between the stock, a put and a call, is such that there exists a

103

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105

process called conversion throuqh which a put can be converted into
a call and a call into a ojt . For example, the combination of
the purchase of the underlying security on margin olus the purchase
of a put is the functional equivalent of a long position in a call
ootion. Likewise, a short sale of stock and the purchase of a call
is the equivalent of a long position in a put option.

Recognizing the necessary interrelationships between put and
call prices, Hans Stoll developed a theory of put and call parity. 9/
According to this theory, and subsequent tests of it, an arbitrage
mechanism tends to keep put and call prices in line with each other
through riskless conversion activities. Stoll pointed out how a put
could be converted into a call (and/or a call converted into a put) at
no risk to the converter. The principle of put and call parity has
been used by other researchers to assess the pricing efficiency of
the ootions market.

_9/ Stoll, Hans R. , "The Relationship Between Put and Call Option
Prices," The Journal of Finance, December 1969. Merton later
concluded that the theorv was applicable only to a European
option, one not exercisable until maturity. See Merton, R. C,
"The RelationshiD Between Put and Call Option Prices: Comment,"
The Journal of Finance, 28 (March 1973) pp. 183-184.

106

B. PRINCIPAL STRATEGIES

1 . Introduction

Options participants can be grouped into three categories: 1) public
non-professional participants, 2) professional money managers, and
3) professional traders and arbitrageurs. The basic purposes served
these participants by the various common types of options transactions
are: to obtain leverage, to hedge positions in the underlying security,
to increase current income from securities holdings, to arbitrage for
profit, to speculate or trade on perceived over -and-under valued situa-
tions, and to facilitate the provision of brokerage and marketmaking
services in the underlying stocks.

Investors have varying user perspectives as they approach the options
market. Traders, for example, attempt to capitalize on undervalued and
overvalued situations by using complex mathematical models and computer
techniques to detect and arbitrage against perceived illogical divergences
in prices. Studies of option price oatterns, however, indicate that while
price divergences do occur which may provide profitable trading opportunities
for professionals the divergences generally are too small for trading
ooportunities by members of the public because of transaction costs.
Other, generally sophisticated, investors perceive an opportunity to adjust
the risk-reward mix of their portfolio of assets in a more precise manner
because of the additional combinations of risk and potential return
opened up to them by the availability of exchange traded options.

io:

Risk management and risk adjusted performance have become basic criteria
upon which professional managerial ability is evaluated. Most individual
investors in options, however, are probably using option purchases and
sales as a substitute for stock purchases and sales. Dealing in options
enables them to take short-term positions in the stock, or shift out of
the stock in the short-term with lower transactions costs; and, for buyers,
it offers greater leverage than would be the case if they were trading
directly in the underlying securities.

2. Ten Basic Strategies

Although there are a great many different options strategies, Harris
Associates, Inc., in its survey of options investors, 10/ listed ten common
strategies that appear to be commonly employed by investors:

Buying

1) Buying options in combination with stock ownership.

2) 3uying options in combination with fixed-income securities.

3) "Pure" buying of options without underlying stock or fixed-
income securities.

Mixed Strategies

4) Buying options against a short position in underlying
stock.

10/ A Survey of Investors In the Listed Cations Market, Louis Harris

Associates for the American Stock Exchange, Inc., May 1976, p. 112.
The source of data for this survey was interviews with a clustered
systematical probability sample of 319 options customers selected
from 5 of the 20 largest options retail firms. The firms were
selected on the basis of various subjective characteristics,
including willingness to cooperate.

108

3) tmying options as a hedge against a short position in
securities related to the underlying security.

6) Selling options hedged against otner related securities.

1) spreading options by buying and selling different options
in tne same underlying securities.

selling

8) selling rully covered options.

y) Selling partially covered options.

10) selling completely uncovered options.

The strategies that the Hams survey identified are as follows: 11/

i) "Pure" ouying of options witnout underlying
stock or rTxeo-income securities

'mis "strategy" is the most commonly employed by options buyers.

It entails a substantially nigher degree of risk than does the simple

investment in tne underlying stocK because relatively large increases

in tne price of tne underlying stocK are required if tne buyer is to

profit trail tnis activity. Wnile the leverage obtainable through the

purcnase of options holds fortn tne potential for large profits if

the relatively large increase in stock prices occurs, such large

increases are relatively infrequent and, tneoretically, are offset

by nore trequent, smaller losses. Moreover, attempts to roll-over

options positions, because of tne frequent payment of commissions

on sucn roll-over transactions, will generally eliminate the

possibility tnat investors on tne average will realize any long-term

11/ The Options study does not endorse or recommend any of the
stategies described at pp. 28-34. They are used only to
illustrate tne common strategies that tne Harris survey found.

!()<>

^rorit train tnis strategy. Tne simple ouying of options is a highly
etricient substitute tor snort-term trading in tne stock. Tne use of
options enaoies a snorx-tenr. traaer to avoid the substantially larger
oociinissions required ana to use less tunas than would be required to meet
tne purcnase of an equivalent position in tne stock. It may thus help
mm to ootain a mucn larger position in a stock with a limited amount
oi capital. It also exposes mm to a risK ot losing his entire investment.

2) selling fiuly covered options

Tnis strategy is a suostitute for the short-term sale of stock.
Anile r.ost investors who write fully coverea options appear to do so in the
nope ot increasing their returns from a given stockholding, the evidence
indicates tnat tney are merely transferring tne short-term risk of small
i.ovanents in tne price ot tne underlying security to tne option ouyer
in excnange tor giving up tne potential for large profits from the underlying
stocKholaing . ±2/ Tne net etfect is that ooth the risks and potential
rewaras or stocK ownersnip have oeen reauced. In effect, the fully
covered writer is engaging in a partial sale of his security position

12/ rterton points out that in quiet periods when little company-
Sj^ecitic information is arriving at tne market, writers will
tena to maKe wnat appear to De greater than normal profits and
outers will appear to lose. However, in tne relatively
mrrequent active periods, tne writers will suffer large losses,
or, lr covered, will forego large profits, and the buyers will
profit oecause movements in stock prices occasionally exhibit
large discontinuities or "jumps" in movement. The writer's large
losses occur just irequently enougn to, on the average, offset the
auaost steady excess return. Merton, Robert C. , "Options Pricing
wnen underlying btock Returns are Discontinuous," Journal of
Financial Economics (1976), p. 132.

40-940 O - 79 - 10

110

for the period covered by the option contract. If he wishes to maintain

a long-term position in the underlying security, but does not believe

that it will rise substantially during the period covered by the option

contract, then he can trade on this belief at significantly lower costs

by writing options than he could by temporarily transferring his stock

ownership. By writing an option, he is effectively taking himself out

of the market for that security until the price moves up or down by the

amount of the premium, except that he retains the right to any dividends

as long as he retains the stock and may retain certain tax advantages

that would be lost on the sale of the stock.

3) Buying options in combination with
present or potential stock ownership

The purchase of calls increases the leverage and risks of a

portfolio holding the underlying stock. Placing all of one's investment

in options, however, does entail substantially greater risks of loss than

either holding the underlying security or holding some portion of one's

funds in the underlying security along with the purchase of call options.

Call options may be purchased for the specific purpose of fixing the

future price of security purchases in circumstances in which an investor,

who currently does not have sufficient money to take the position in the

stock desired, anticipates additional funds in the future.

Ill

4) buying options in compination with fixed-
income securities

Tnis ^articular approacn to buying options is frequently used as

an illustration of a conservative use of options, in tnat tne risx. of

sucn a comoined invest_inent can oe significantly lower tnan investment

in tne underlying security alone. Wnetner it is more or less risKy depends

on tne proportion- of options in tne combined investment. In effect, tne

purcnase of options involves a nign degree of risK and tne purchase of

quality fixed- inca.ie securities a relatively lower degree of risk. There

are many possioie variations as one adjusts the proportion of the investment

tnat is in rixeo- income securities and alcernatively in options. While

talis strategy is frequently discussed in options articles and publications,

only a very small percentage of investors actually employs tnis technique. 13/

5) buying options against snort positon in
underlying stock

options can oe usee by traders to hedge a short position in the under-
lying stocx. or alternatively to neage against a decline in the underlying
stocx. because tne snort seller is exposed to very substantial losses
if ne is wrong (and tne stock price rises substantially), his potential
losses can oe limited oy the purcnase of call options. If he is right
(and tne stocK price declines suostantially) , the premium paid for the
calls is the cost of nis partial protection against large losses and offsets

13/ bee narris Keport pp. Iu7-i0b. Only 5 percent of the investors in
tnat survey used this strategy.

112

a portion of his gains. Similarly, an investor wishing to hedge against
a substantial loss in a stock held in a portfolio might purchase a put
option.

6) Spreading options: buying and selling different
options in the same underlying securities

Traders and arbitrageurs attempt, whenever possible, to buy under-
valued and sell overvalued options and to hedge positions taken in options
and in the underlying securities in a manner which capitalizes on perceived
undervalued and overvalued situations. The technique of spreading involves
the taking of positions in different options in the same underlying securities
on opposite sides of the market. Spread positions also may involve holding
an option with a different exoiration date from that of the option written,
holding and writing options with different exercise prices but with the
same expiration date, or holding and writing options with different
expiration dates and exercise prices. Because spreading activities require
the near simultaneous execution of buy and sell transactions and correct
judgment respecting the appropriateness of the relative prices of the
ODtions contracts used in the spread, a high degree of sophistication
and knowledge of options and option values is required in order to profit
from spreading activities as well as close attention to total transactions
costs.

7) Buying options as a hedge with respect
to related securities

Some stocks without options tend to move in relation to other stocks,

on which listed options are available. Options can be used to hedge positions

113

in tnese other related securities witnout listed options. Consequently,
options might oe used to necige a position in a security ot another company
in tne saiiie industry. In aadition options may oe used to hedge a position
in uonas convertible into tne stocK underlying an option.

B) belling options to nedge against other securities

Tne writing or options provides a hedge against smaller short-term
moves in tne price ot a related security. For example, a block: positioner
naving a long ^josition in a related stock or convertible bond that has
ueen purcnased trail a customer may wish to hedge his risK until he is
auie to sell the securities in tne market. He might write options and
erreccively snitt some ot nis short-term risK exposure in those securities
uo options buyers until nis position is sold at which time he can close
out nis options positions by repurchasing calls in tne market. Similarly,
ne mignt write puts against snort positions in the security.

9) belling partially covered options

Tne sale ot partially covered options involves tne writing of more
tiian one option contract for eacn hundred snares of the underlying security
neio in porttolio. The rationale for a partially uncovered position is
tnat tne change in tne price of tne option tnat usually occurs, for those
not oeep-in-tne-iioney s a result of a change in the underlying stock

14/ i\ call option, which is exercisaole tor substantially less than the
current marKet price of tne underlying stocx, is referred to as
being "deep-in-tne-noney, " and conversely for a put option.

114

is not on a dollar- tor-dollar basis. Therefore, an option writer may
believe that nis risk from price cnanyes in the option contracts he has
written is adequately hedged oy tne price change that occurs in the shares
or the underlying security being used as a cover. For example, contracts
tnat are out-or-tne-money lb/ may rise in price by an amount much less than
tne increase ot the stock. Tne risk of partially covered writing activities
is tnat tney depend upon tne use of a delta factor or hedge ratio which
cnanyes soaietiiies rapidly, so that to the extent tne option position is
uncovered tne exposure is tnat of a writer of an uncovered option.
lUj sex liny completely uncovered options

Tms activity involves the writing of options without a position
m the underlying stock. Tne risks are large, even larger than the pure
ouymg ot options. Tne writer of uncovered options can expect a profit
limited to the amount ot tne premiums received, but, like a short-seller,
ne nas theoretically unlimited potential liability if the market moves
against him* in tne case of a call, and a loss wnich is limited only by
tne exercise price in the case of a put.

3. Survey of Investor Use of Option Strategies
Tne Harris survey found that the buying of options in combination
witn rixed-income securities was the least used buying strategy among
individual options investors with only 5 percent using that approach.

lb/ A call option, which is exercisable at a price higher than the current
jfiarKet price of tiie underlying stocK, is referred to as being
"out-of-tne-money," and conversely for a put option.

115

uniy by percent 01 inoividua± options investors were even aware of that
strategy. 16/ Tne simple strategy of buying options alone (pure buying)
was, in lact, tne strategy used Dy b8 percent ot tne persons surveyed. 17/

aiiong individual investors, the Harris survey found that 74 percent
nad used some Kind ot pure ouying strategy, 61 percent had used some form
ot pure selling strategy, ana 18 percent had mixed strategies involving
both ouying ana selling activities. Among investors who utilized pure
selling strategies, 56 percent did so on a fully covered basis, 19 percent
on a partially covered oasis, and 19 percent on a completely uncovered basis.
Muong individuals investing a total of $2,500 or less in options, 49 percent
engaged in pure Duying witnout tne underlying stock or fixed-income secu-
rities, 21 percent in buying in combination with stocK ownership, and
41 percent nad engaged m selling fully covered options. 18/

in contrast to individual investors, 79 percent of the institutional
investors surveyed concentrated their activities on the selling of fully
covered options. Only 25 percent of institutions engaged in the pure
ouying or options witnout tne underlying stocK or fixed income securities;
and 12 percent purchased options in combination with stock ownership.
Only 7 percent of institutional investors purchased options in combina-
tion witn fixed- income securities. Many institutions are restricted to
more conservative covered writing activities by eitner legal or self-
imposed guidelines for investing. The Harris survey reported that 35

ib/ Harris report, pp. 107-108.
17/ Harris report, p. 108.
16/ Harris report, pp. lObft.

116

percent ot responding institutions were restricted to covered writing,
ana b6 percent ot tnose institutions witn $1 million or more in assets
were so restricted. 19/

Anotner survey ot individual options investors undertaken by the
i-ianayeiitent Analysis Center, Cambridge, Massachusetts and sponsored by
tne CBOc found tnat the strategies followed by options investors were:
mostly Duying (28 percent), mostly spreading (6 percent), mostly selling
uncovered (4 percent), and mostly selling covered (62 percent). 20/ While
tnis latter study cutters witn respect to tne specific questions that
were asxed ot investors, it found, as did tne Harris survey, that the
two strategies most frequently followed Dy investors were the simple
ouying ana covered writing of options contracts. The percentages cannot
ue uirectly compared because, among other things, the AMEX sponsored survey
asKea investors wnether they haa usea particular strategies while the
CtsGE sponsorea survey asked investors which strategy tney most frequently
rolloweu. Neitner survey included interviews with broker-dealers, a
professional, out extremely important group, using options in their
activities. blocK-positioning firms, marketmakers and otner broker-
aealers maKe extensive use or options in providing dealer services to
the public market, as is described Delow in the Trading Practices
cnapter.

19/ Harris report, pp. 109ff.
20/ KoDbins, et al p. 74.

117

As the aoove indicates, an options strategy can be used for a
stocK strategy and stocK and options can oe use in combination to
acnieve alternative investment strategies. Exhibit I (attached)
sets out a detailed list of now various stock and options strategies
can ue used as a suostitute for other stock, and options strategies.

4. Writing Options tor Premiums

wmle all of tne above strategies are used by investors, options
advertising oy broker-dealers and sales presentations by registered
representatives often empnasize the writing of covered options to obtain
cranium income and as a means to reduce tne risK of adverse market price
uovements, as is discussed more fully in the cnapter on Sales Practices.

Tne effects of altering tne risk- return ratio through options, however,
generally is not empnasized by broker-oealers and their registered repre-
sentatives or by published materials currently available to the general
jjuolic. ror example, the following excerpt from a handbook on options
states:

arter you reao tnis dook, you will never be satisfied
with less tnan 4U percent return, compounded annually.
Tne more you Know about tne stock market, the more
you realize that options writing is tne only way to
invest. 21/

une west Coast brokerage firm's radio advertisement conveyed a similarly

zl/ auster, Roil, Options Writing and Hedging Strategies, Hicksville,
New YorK, i975, p. 3.

118

optimistic view of options writing :

For a substantial number of investors, selling Call
Options is producing premium income in the neighborhood
of 12% to 20% on many good stocks. That's in addition
to tne stocxs' regular dividends. Of course, like
any investment, there are risks to consider as well
as opportunities.

Tnese statements focus on the premiums that at times are available

on tne sale of options and seem to imply that the overall rate of return

on a securities portfolio can be increased by tne sale of options. They

ignore tne effects on overall return that result from reducing risks when

stocxs and options are efficiently priced. It can be shown that portfolios

including options can be constructed which incorporate less risk and lower

potential return than an investment in the underlying stock. In an article

appearing in tne Journal of Business, Merton, Scholes and Giadstein reported

on tne simulated return on a fully covered writing program for a portfolio

ot 1J6 stocKs on whicn listed options were available as of December 1975

over a 12-1/2 year period from July 1, 1963 to December 31, 1975. 22/ Options

prices were simulated using a derivation of the Black Scholes options

pricing model although they also included dividends. Merton, Scholes and

Glacistem concluded that investors can reduce the risk exposure for a

portfolio of stocks through writing options but that, over a period of

time, writing options on a portfolio will reduce the expected rate of

return. Tney also concluded that the premium on covered call writing

22/ werton, Rooert C. , Scholes, Myron S. , and Giadstein, Mathew L. ,

"The Returns and Risk of Alternative Call Option Portfolio Invest-
ment strategies, " Tne Journal of Business, April 1978, p. 189.

119

should not be considered extra income to be added to the usual return

on a stock investment as some brokerage firm advertisements have implied. 23/

Merton, Scholes and Gladstein summarized the results of their study

as follows:

Because the levels of both option premiums
and expected returns will vary depending on
the perceived levels of volatility for the
underlying stocks and interest rates, an
unconditional estimate for the expected
return on a fully covered strategy is
difficult to make. However, based on the
simulations, an expected semiannual return
of between 3% and 4% appears to be a
reasonable estimate for an at-the-money
fully covered strategy when the expected
returns on the underlying stocks are
between 5% and 6%. The fully covered
strategy will frequently produce realized
returns somewhat higher than the expected
level. But because of the negative skewness
of the returns, these higher returns will be
counter balanced by the relatively infrequent
but substantially lower returns that will
be realized if the underlying stocks decline
sharply. 24/

While the Merton, Scholes and Gladstein study concluded that a consistent

practice of writing covered options would most probably reduce the overall

rate of return on the covered call writer's stock portfolio, it also concluded

that the covered call writer could reduce the volatility of the rate of

return. Based on their simulated 136 stock sample, the study concluded

that a consistent practice of writing covered calls would have reduced

the standard deviation of the portfolio returns by approximately 70 percent

23/ Merton et al, pp. 213-214.
24/ Ibid., pp. 213-214.

120

it m-tiie-uoney options were sold, by aoout 5b percent if at-the-money
options were sold, 25/ ana by 35 percent if the out-of-the-^noney options
were sold. 26/

altnougn tne rterton, Scholes and Glads te in study relied upon simula-
tion, tneir results correspond with economic theory that there is a basic
correlation in the long run between risk and reward. While their study
would seem to imply tnat tne purchase of options in combination with fixed-
income securities would have been beneficial over this 12-1/2 year period,
tnis period was cnaracterized by the largest bull market and the most
severe oear marKet since 192y-iy32. Unfortunately, comparable simulations
were not undertaKen tor "pure buying" strategies, tne one most commonly
used by buyers. However, the Merton, Scholes and Gladstein study demonstrates
tne need tor broKers and dealers to have studies to back up any claims
to customers concerning potential returns on options, as is recommended
in tne cnapter on Sales Practices.

2b/ wnen an option's exercise price is tne same as the price of its
underlying stocK, the option is said to be at-tne-money.

_26/ Ibid. , pp. 2uy-21u.

121

EXHIBIT 1

The Relationship Between Puts, Calls,
Straddles and Stocks

The relationship between puts, calls, straddles and stocks
is summarized below in terms of the risk and rewards resulting
from stock price movements during the life of the option to illustrate
the relationship between stocks and options positions. A stock position
whether held alone or in combination with options does not have
a limited life as does the option. The purchaser or holder of a put,
call or stock is referred to as being long, and the seller of stock
which is not owned, or the seller of a put or call is referred to as being
short. In summarizing the relationship below, each reference to stock
long or short is to 100 shares of stock. It is assumed that the
exercise price and expiration dates are the same for any combination
of either puts or calls or both and that the purchase price of a long
stock position or sales price of a short stock position is the same
as the exercise price of the options. It is also assumed that the
premiums received on the sale of a put or call would be the same as
the premiums paid on the purchase of a put or call, although this would
rarely be the case. In addition, the following summary does not cover
the different amounts of capital and margin that must be used to
establish the different positions or the effect of commissions
and dividends. In most instances, combining options and stocks

122

positions in the strategies listed below would be more costly
than the equivalent single stock or option strategy with respect
to which it is equal.

Long Stock = long call and short put. Buying a call and selling a put
with the same exercise price has the same market risk reward during
the life of the option as owning stock because the long call provides
the right to a benefit from an increase in the stock price and the
short put results in having the risk of ownership in the event of
a stock price decline.

Short Stock = long put and short call. Either of these positions
benefits from a stock price decline but provides no protection against
loss in the event of a stock price increase.

Long Call = long stock and long put. A long call provides the right
to benefit from an increase in the stock price but a premium has been
paid to limit loss. Similarly, buying a put to protect a long stock
position involves paying a premium to limit loss.

Long Put = long call and short stock. The short stock position will
benefit if the stock price declines, but the loss in the event of a
stock price increase is limited to the premium paid for the option.

Short Call = short stock and short put. The maximum profit on either
position is limited to the premium on the sale of the option (except

123

broker-dealers may also earn interest on the proceeds of the short
stock position). Neither oosition provides protection aqainst loss
in the event of a stock Drice increase.

Short Put = long stock and a short call. The maximum profit on

either position is limited to the premium on the sale of the option

and the holder of either Dosition retains the risk of ownership
in the event of a stock price decline.

Straddle; A straddle is a combination of positions. A long straddle
will become profitable if the underlying stock trades outside a pre-
determined range (generally measured by the premium and transactions
costs if the exercise prices of the options are the same) and a short
straddle will become profitable if the underlying security trades
within a predetermined range measured by the net premium received.

Long straddles can be created in different ways. A long straddle
can be constructed combining (1) long put and a long call or (2) short
stock and 2 long calls or (3) long stock and 2 long outs. (Note: A
lona Dut is equal to short stock and a long call. Thus short stock
plus 2 long calls equals a long put and long call. Similarly, a long
call equals long stock and a long put. Thus long stock plus 2 long
puts equals a long call and a long out . )

124

Short straddles can also be created in different ways. A short
straddle can be constructed by combining (1) a short put and a short call
or (2) long stock and 2 short calls or (3) short stock and 2 short puts.
(Note: A short put is equal to long stock and a short call. Thus long
stock and 2 short calls equals a short put and a short call. Similarly,
a short call is eoual to short stock plus a short put. Thus short stock
and 2 short puts equal a short call and a short put.)

CHAPTER III
THE USE OF OFriONS BY PROFESSIONAL TRADERS

INTKUJJUCriU^

wnen listed options trading began in 1973, a new range of trad-
my strategies, utilizing both stocks and options, became commonly
availaole to persons who wished to purchase or sell exchange traded
securities, rtany market participants, including retail customers,
institutions and professional traders, began using options along
with stocKs to try to improve their investment performance, or to
heuge their investments against market price movements. Unfortunately,
along^with tne new trading opportunities offered by options, came
new opj-ortunities tor abuse. In instituting the Options Study in
October 1977, tne Commission noted that certain abuses had occurred
in tne trading ot listed options (alone or in conjunction with trading
in underlying stocKs) and expressed concern whether the self-regulatory
organizations' surveillance and compliance systems could detect
ana prevent these anuses. 1/

as part of its task, theretore, the Options Study undertook
a review ot options trading practices used by certain professional
traders, wore than 10U persons actively involved in, or affected
by, listed options trading were interviewed, including market pro-
ressionals and the statf members of the self -regulatory organizations
responsible for the oversight of options trading practices. Options

1/ Securities Excnange Act Release No. 14056 (October 17, 1977)
( "October Release" ) .

(125)

40-940 O - 79 - 11

126

Study staff members visited the floor of each options exchange
and the options trading desks of several broker-dealers. Trading
records were obtained from selected broker-dealers, options specialists,
and marketmakers in order to document the details of activities
discussed during the interviews and observed during trading. In
addition, the Options Study reviewed sworn testimony and exhibits
from numerous options trading investigations conducted by self-
regulatory organizations and by the Commission's staff. The Options
Study, however, did not conduct independent investigations of
particular trading situations. Nor was the Options Study able to
review and analyze trading data or investigations that the self-
regulatory organizations initiated in sufficient detail to form
the basis for regulatory recommendations. As a result, further
study will be required to determine whether specific trading patterns
can be identified which should be the subjects of Droscriptive
rules and to formulate appropriate rules where necessary. 2/

In reviewing options trading practices, the Options Study fo-
cused primarily on the activities of "market professionals," —
that is, persons or entities:

(1) who trade on the floors of the exchanges, such as

marketmakers (CBOE) (MSE) (PSE); options specialists
and registered options traders (AMEX) (PHLX); and stock

2/ See p. 58, infra.

127

specialists and registered traders (NYSE); (collectively
referred to as "marketmakers" ) , or

(2) who are exchange members and initiate orders for their
own account from their offices ('uostairs firms"); or

(3) who effect a large volume of securities transactions
as customers of exchange members (,: institutions"
including so-called "hedge funds").

Accordingly, the chapter is a survey of the manner in which market
Drofessionals use options in the course of their activities and
should not be considered a complete description or analysis of the
manner in which all market participants use, or might use, options.
In addition, the chapter summarizes various trading practices identified
in the October Release and which may have involved violations of the
Securities Exchanqe Act and Commission rules adoDted thereunder, as
well as rules of the self-regulatory organizations.

All market professionals have two privileges which distinguish
them from, and give them advantages over, other market participants.
First, they have quicker access to exchange trading facilities -
because as members they are permitted to trade on the floor of an
exchange or otherwise have preferred access to the floor of an ex-
change through telecommunication systems or messengers. This access
to the trading floors enables market professionals to respond quickly
to information likely to affect the price of a security, such as un-
usual supply or demand for a security, wire service news about a par-
ticular issue, or general economic news. Second, market professionals

128

generally ao not incur transaction costs (e.g. , commissions) or trade
in sucn volume that the costs they incur are significantly reduced.
Mduitional advantages, such as favoraole margin treatment or access
to customers' margin securities, are available to some, but not all,
marKet proiessionals.

Tnese advantages allow market professionals to engage in certain
options trading strategies - such as arbitrage - which are not feasible
lor retail customers. Tne advantages also present market professionals
witn greater opportunities to engage in trading practices which violate
the securities laws than are afforded other market participants.

wnile uiarket proiessionals, as a general rule, use their
advantages to maximize their own trading profits, they also perform
userul t unctions in tne market place. Their most significant con-
tribution to the market occurs when their participation makes the
pricing of securities more efficient, and makes the markets for
both stocK and options more liquid. By making these contributions,
tne trading of market proiessionals helps assure that the prices
pUDlic customers pay for securities are fair and that these prices
quicKly reflect the host current and relevant information available
aoout the securities. In addition, marketmakers assume certain
obligations to the marketplace which upstairs firms and institutions
do not.

Tne sections below will first describe the functions and
legitimate trading activities of market professionals. Next,
questionable options trading practices will be examined. Finally,

129

certain trading rules will be discussed which are of particular
relevance to options trading by market professionals.
1. ON FLOOR MARKET PARTICIPATE
a. Obligations

Market professionals who trade on the floors of options ex-
changes ( "marketmakers" ) either trade for their own accounts,
act as agents for others, or, in some cases, do both. In 1977,
1,153 registered broker-dealers reported options marketmaking
activities on national securities exchanges. Their combined gross
profit from these activities was $33.1 million, although almost
40 percent (413) of the dealers reported losses, which in the
aggregate amounted to $15.9 million.

There are two basic marketmaking systems used by options
exchanges. The options specialist system of the AMEX and PHLX,
(similar to the system used on most stock exchanges), uses an
options specialist, who is assigned an options class or classes
for which he is obligated to make a market. The specialist is
permitted to act both as broker (agent) and dealer (principal)
in the options classes to which he is assigned. As broker, he
holds and executes orders for other members; as dealer he trades
as principal for his own account. The specialist system also relies
upon registered options traders ("ROTs") to act as dealers and to
perform a marketmaking function. A ROT is not assigned to or re-

130

quired to limit his trading to a single location or "trading post"
and he performs a marketmaking role when trading for his own
account. 3/ Unlike a specialist, however, a ROT may not act
as both a broker and as a dealer in the same options class during
the same day.

The other options exchange system for making markets, used by
the CBOE, MSE, and PSE, is the competing marketmaker system. This
system, as its name suggests, uses marketmakers to compete with
each other to make markets in the various options classes traded
on the exchange. The competing marketmaker system is characterized
by a separation of the broker and dealer functions. The broker (agency)
function for each options class is assigned to a "board broker"
on the CBOE 4/ and to an "order book official" on the MSE and PSE.
The marketmakers perform the dealer function, although they may also,
under certain circumstances, act as brokers. Unlike options specialists,
the marketmakers may trade at any post on the exchange floor. Under
the rules of the exchanges, marketmakers may not act as dealers and
as brokers in the same options class on the same day. 5/

3/ See, e.g. , AMEX rule 958. In practice, a ROT's marketmaking
obligation has not been extended beyond the requirement to
purchase or sell one options contract.

4/ The Commission recently approved a rule proposal of the CBOE to
abolish its current board broker system and replace its board
brokers with order book officials who would be salaried employees
of the CBOE. See, Securities Exchange Act Release No. 15490
(January 11, 1979).

5/ See, e.g., CBOE rule 8.8.

131

Under Commission and options exchange rules, specialists, ROTs
and competing marketmakers have an obligation to trade for their
own accounts so as to maintain a fair and orderly market (referred
to as their "affirmative obligation") and not to engage in trading
which is inconsistent with this obligation (referred to as their
"negative obligation"). 6/ This generally includes an obligation to
engage in dealings for their own account in order to maintain price
continuity and to minimize effects of a temporary disparity between
supply and demand, immediate or reasonably anticipated. 1/

Exchanges using both the specialist and the competing marketmaker
systems permit members called "floor brokers" to execute agency trades
on the exchange floors. Many floor brokers are employees of member firms

6/ See, e.g., 17 CFR 240.11D-1, CBOE rule 8.7.

7/ The Options Study did not evaluate the performance of options
specialists or marketmakers in meeting their affirmative and
negative obligations under the Exchange Act or options exchange
rules. Inasmuch as many significant regulatory decisions (such
as the availability of favorable margin treatment and the ability
to effect transactions on an exchange for one's own account) are
predicated upon these obligations, the Options Study believes
that a thorough review should be undertaken to define these
obligations more precisely and to determine whether options
specialists and marketmakers are meeting these obligations.

132

who primarily or exclusively execute orders for their firms' proprietary
trauma accounts and tor public customers of the firm. Other floor
oroxers, sane times called "two dollar brokers", are self-employed and
execute oraers on behalf of marketmaKers and member firms which
either do not enploy tneir own floor brokers or which, on occasion,
need to supplement tneir existing personnel. Floor brokers, unlike
specialists, kOTs and marketmakers , have no marketmaking responsibilities.

b. Privileges

In exchange for their marketmaking obligations, marketmakers
enjoy certain advantages. First, they have access to information
regarding the market wnich is unavailable to persons not physically
present on the tloor. They may, for example, be able to gauge the
supply ana demand ror a particular security by observing the flow
ot orders at that security's trading post. On the CBOE, MSE and PSE,
traders can also obtain information concerning prospective transactions
Dy ooserving, on a television-like screen at each trading post, the
uest puolic bia and asked quotations tor an options series that the
limit order book contains, b/ More subtle pieces of information
are also available to marketrivakers . Because of their familiarity

b/ On the AMEX and PHLX, however, the options specialist is generally
tne only person wno is aware of the limit orders which he holds
in nis "book. " AMEX has recently begun to experiment with the
leasiDiiity ot exposing portions of its options specialists'
books to other market participants.

133

with tloor personnel, tne traders may recognize a certain floor broker
who is Known to represent certain large institutional customers, and
may thereby anticipate, as lie moves into the trading crowd, a large
order wnicn may be ellected in one or several transactions. They may
also ue aDle to identity and interpret tne significance of specific
trading tecnniques employed by a particular floor broker or marketmaker.
Pernaps most significantly, the marKetmaker can know of, and react
to, changing quotations and executed transactions as soon as they
occur, most oil-floor market participants do not have access to this
"iloor- related" information until it is publicly disseminated; as a
result, this information is useful only to those on the exchange
tloor.

Second, options marketmakers receive special margin treatment for
tneir options and stock transactions to permit them to provide liquidity
wnen necessary. 9/ Their options transactions are not subject to any
margin restrictions out are subject to financial responsibility require-
ments. 1U/ With respect to their stock transactions, options market-
maxers are given relaxed margin treatment. 11/ For example, if an options

9/ bee Cnapter VII.

10/ Id.

11/ I'larketmaxers and other traders affecting transactions as dealers
on the excnange tloor are designated Dy the options exchanges as
"specialists" lor purposes of the Exchange Act. See, e.g. , CBOE
ruie b.l. This designation permits these traders to receive the
lavoraoie treatment accorded all specialists under Federal Reserve
board margin regulations, adopted under Section 7 of the Exchange Act,

134

marketmaker hedges his options positions with stock, and then liquidates
the stock position within five days, he, unlike a public cus toner,
is not required to make any margin deposit with his clearing firm.
This advantageous margin treatment has permitted options marketmakers
and specialists to assume and liquidate stock positions within five
days without meeting initial margin requirements. 12/ In addition,
like all exchange members, they do not generally pay commissions on
their options transactions. They are therefore able to trade frequently,
to profit from small price changes, and to assume securities positions
at lower costs than non-members.

Finally, like other professional traders, marketmakers often
have access to computers which use various pricing models to compute
theoretical values for options. 13/ This information helps traders
to identify trading opportunities, analyze alternative strategies,
and monitor their existing securities positions. Marketmakers
are able to study computerized pricing models in their offices (or
the offices of their clearing firms) both before the trading day
begins and at any time during the day, although they have to leave
the exchange floor to do so. The computerized pricing models also

12/ A description of this practice, and the Options Study's recom-
mendations on this subject, are contained in Chapter VTI.

13/ For a more complete discussion of the theoretical value of an
option and the use of delta analysis, see Chapter II.

135

provide information on tne "delta" ot an options series, which is a
mathematical relationsnip oetween underlying stock and options prices
oased on relatively small snort-term price movements in the underlying
stocK. 14/ Delta factors are used by traders to calculate the exposure
to marKet risK inherent in tneir options and stock positions, and to
adjust their positions to avoid unacceptable risk. 15/

c. Options t raging strategies

Tne nvarketmaKer uses his advantages in the marketplace to earn
trading prorits lor ms own account. In accomplishing this end, he may
employ a variety of trading strategies designed to maximize profits
and to enaoie mm to minimize or control the risks of his options
positions.

Aitnougn each marKetmaxer ' s method of trading is, to a certain
extent, unique, tnree general approacnes to options marketmaking are
cohuion. These are categorized as "scalping", "spreading" and
"position trading."

Tne term "scalping" describes a trading strategy in which a trader
tries to Duy options at tne bid price (e.g. , 1-1/2) and sell them
at the asKed price (e.g. , l-5/tt) in order to profit from the differ-

14/ Id.

lb/ ueita analysis is also used Dy some clearing firms as a measure
or tne risK exposure ot tne marketmakers tor wnom tney clear
transactions. For a description of the delta formula, and its
use as a risK measuring device by clearing firms, see Chapter VII.

136

ential, (in this case, 1/8 of a point). This trading strategy requires
a rapid turnover of positions, both to limit risk and to achieve mean-
ingful profits from the narrow spread between the bid and asked quotations.
The term "spreading" describes the simultaneous or nearly simultaneous
purchase and sale of two different options series of the same class
in order to reduce the risk associated with a simple long or short op-
tions position. Frequently, options perceived as relatively undervalued
are bought and those perceived as relatively overvalued are sold. This
assessment of each option's value is derived either from a computerized
pricing model or from the marketmaker ' s subjective analysis. "Neutral
spreaders" attempt to maintain offsetting options positions in
order to minimize the impact of price movements of the underlying
stock on their spread positions. Profit is earned as market forces
"correct" the relative valuations of the options. Position trading
refers to several trading strategies in which the marketmaker
acquires longer term options positions, generally by spreading
or call writing against long stock, which are based upon his opinion
of the anticipated future price movements of the underlying stock.
The fundamental elements of scalping, spreading and position
trading are summarized in Table 1.

137

TABLE 1

SCALPING

SPREADING

POSITION TRADING

Basic Strategy

Use of Options
Pricing Model

Buy/ sell all as-
signed classes at
bid/offer to earn
differential

Buy relatively
undervalued op-
tions; sell re-
latively over-
valued options.
Reduce risk
associated with
simple long or
short options
positions

Inherent part
of strategy

Speculation on
market movements

Occasionally

Opinion on
Underlying
Stock

Not necessarily

Inherent part
of strategy

Time Position
Held

As briefly as
possible - rarely
overnight - for
this reason
scalpers are
often called
"day traders"

Makes adjustments
and constantly
changes positions

Frequently until
expiration

Use of Stock

Occasionally
when options
cannot be used
or are not an
economical
hedge

Inherent part of
some strategies

Capital Needed

Vulnerability
to price
movement in
underlying
stock

Minimal

Relatively little
vulnerability be-
cause of rapid
turnover of
small positions

Moderate

Vulnerable to
large price
fluctuations
in underlying
security;
neutrally hedged
for small move-
ments

Substantial
Substantial

138

While individual marketmakers generally favor one approach
to trading, most remain flexible in responding to market conditions.
A scalper may become a spreader if he is unable to close out a posi-
tion at a reasonable price. A spreader may become a scalper by closing
out one side of a spread in response to an attractive bid or offer or
upon receipt of an exercise notice for the underlying stock. An options
marketmaker may begin the day with a planned approach and then be forced
to reevaluate his trading strategies in response to order flow, his
marketmaking obligations, or the price movement of the underlying
stock. N.

d. Stock/options trading strategies

The Commission has prohibited stock specialists and registered
stock marketmakers on the NYSE and AMEX from trading options in their
specialty stocks or stocks in which they hold positions 16/ because,
among other reasons, of the potential for manipulative and other improper
activity inherent in such an arrangement. 17/ Marketmakers, specialists
and ROTs on the options exchanges, however, have been permitted to trade
the equity securities underlying the options in which they make markets.

16/ In 1977, the Commission determined to permit specialists and
odd-lot dealers on the floors of the regional stock exchanges
to trade listed options on their specialty stocks and to allow
marketmakers on those exchanges to trade listed options with
respect to underlying securities in which they held a position
because "the manipulative potential inherent in [permitting such
trading] appears relatively insignificant." See, e.g. , Securities
Exchange Act Release No. 13269 (February 16, 1977), No. 13270
(February 16, 1977), and No. 13272 (February 16, 1977).

17/ See discussion at Chapter VII.

139

Several economic factors, however, would seem to discourage the
use of stock by options marketmakers in devising strategies. First,
when an options marketmaker wishes to buy or sell stock, the transaction
must be effected through a stock exchange member firm who charges
the options marketmaker a commission for the service. 18/ While these
charges are generally lower for options marketmakers than for market
participants who are not exchange members, they are still higher
than the minimal clearing charges which these traders incur for
their options transactions. Second, if the options marketmaker
purchases the stock on credit - and he almost always does - the
amount of interest he must pay his creditor (usually his clearing
firm) is higher than interest he would pay for an equivalent options
position, since- the corresponding stock position will cost more
and the amount borrowed is obviously greater than for the equivalent
options position. Third, while an options marketmaker 's options trans-
actions are exempt from margin requirements, his equity positions,
used to hedge his options positions, are subject to a minimum 25 per-
cent margin requirement under Regulation T if not sold within five
business days after purchase. Fourth, a marketmaker 's stock sales
(but not purchases) are subject to the New York State transfer tax
if the sales are executed on the NYSE or AMEX, which are the primary
markets for all stocks underlying listed options. Fifth, the options

18/ If the options marketmaker is also a member of the stock exchange
where the transaction was executed, commission charges, with
the exception of floor brokerage, may not be incurred.

140

Hour trader nas immediate access to stock options quotation and trans-
action information but, because the stock transaction and quotation
information availaole on tne options exchange floor may be stale or
unreliaole, ne may nave to use personnel on the stock exchange floor
employed by nis clearing firm or tne firm through which he executes
stock transactions to obtain reports of stock quotations and transactions
ac a particular moment. This results in delay in the marketmaker ' s
receipt of pricing information and is a service for which the market-
maxer must ultimately pay, eitner directly or indirectly. Finally,
to place a stock oraer, a marketmaKer must leave the options trading
crowd (or at least momentarily divert his attention from options trading
activity), ana, as a result, may lose the opportunity to make an ad-
vantageous options traae.

Altnougn these economic considerations would seem to make stock
transactions sohiewnat unattractive tor options marketmakers , some
marKetmakers nonetheless appear to use stock extensively in their
trading strategies.

a marKetiiiaker may use stock to hedge an options position when
an options hedge mignt not be available. For example, if a trader
purcnased a large number of soon-to-expire call options in the only
near term m-tne-money 19/ series available for that options class, he

IV A call option is said to be "in-the-money" if the underlying
security's ^rice is greater than tne option's exercise price.
A put option is "in-the-money" if the underlying security's price
is lower than tne option's exercise price.

141

might be unable to hedge that position through the sale of options
in another series of that class (an "options hedge") because a very
large number of contracts would be necessary to offset the risk of
the initial options position. Such a large sale transaction might
be undesirable because of the market impact of buying or the
liquidity costs of selling the position. Moreover, if the options
hedge could only be accomplished through the writing of more than
1,000 contracts, the trader would be precluded from making such a
sale because of position limit rules which prevent him from holding
more than 1,000 options contracts on one side of the market. 20/

Options hedges are most likely to be unavailable in options classes
that are not actively traded or in which a limited number of series
exist. This may be more true if listed puts are not available for
a particular stock. In such instances, options traders may be more
likely to use hedging strategies involving the underlying stock.

In order to assess the extent to which marketmakers engage in
stock trading, the Options Study reviewed summaries of CBOE market-
maker activity in NYSE stocks underlying CBOE options. 21/ The review
covered six weeks of trading activity beginning in June 1978. This

20/ For a discussion of these position limit rules, see infra at
65-68.

21/ These summaries were prepared by the CBOE and did not cover

stock transactions by non-CBOE options marketmakers. Additionally,
the period under review included an expiration week and accordingly
may not be representative of the volume of stock transactions by
marketmakers at other times.

40-940 O - 79 - 12

142

review showed that stock trading by CBOE marketmakers as a group exceeded
15 percent of the reported stock volume in an average of four NYSE
listed stocks each day. On each day reviewed, CBOE marketmakers
purchased or sold more than 20 percent of the shares traded on
the NYSE in at least one issue. On occasion, the options marketmaker
activity exceeded 50 percent of the trading in a particular underlying
stock. In several instances, the marketmakers had no options position
in the stock in which they had been trading and thus the transactions
appear to have been unrelated to their mar ketma king obligations. 22/
As a general rule, options marketmakers who are well capitalized
tend to trade more shares of stock than traders with less capital because
they can afford the costs associated with maintaining a stock position
(including margin, if necessary), and because they can afford to assume
large options positions for which an options hedge may not be available.
The following tables, based on data analyzed by the Options Study, suggest
that well-capitalized marketmakers and specialists tend to have larger
stock positions relative to their options positions than those who are
less well-capitalized.

22/ These summaries indicate that stock transactions by CBOE market-
makers constituted a substantial amount of the transactions
in the underlying stock for the period under review. The
subject of stock transactions by options professionals, and
particularly the impact such transactions have on stock prices,
would appear to be an appropriate subject for further study
by the Division of Market Regulation. The relationship between
the stock trading by options marketmakers and the margin
regulations is discussed in Chapter VII.

143

Table 2

As of September 30, 1977

Account Equity ($)

Number of
Marketmakers

34 23/

Aggregate Long

and Short
Options Positions

Aggregate Long
and Short
Stock Positions

$ 194,575

Per a

Stock

to Opt

sntage of
Positions
ions Positions

less than 0

S 795,952

24%

0 - 4,999

272

2,728,885

275,861

10%

5,000 - 24,999

219

11,746,773

3,711,484

32%

25,000 - 99 999

197

31,313,658

0,325,927

33%

100,000 and over

141

92,928,614

2,110,035

77%

Table 3

As of December 30, 1977

Aggregate Long Aggregate Long Percentage of
Number of and Short and Short Stock Positions
Account Equity ($) Marketmakers Options Positions Stock Positions to Options Positions

less than 0

24/

$ 5,983,646

422,937

0 - 4,999

272

4,047,942

219,128

5,000 - 24,999

219

18,414,193

1,609,157

25.000 - 99 999

214

45,655,782

9,234,243

21%

100,000 and over

154

144,495,299

88,740,095

62%

23/ This does not include five MSE market makers who reported no stock
or options oositions.

24/ This does not include six MSE marketmakers who reported no stock
or options oositions.

144

2. UPSTAIRS FIRMS

Broker-dealers who initiate their proprietary trading off exchange
floors ("upstairs firms") principally use options to generate arbitrage
and trading profits. They can profit from such transactions primarily
because of certain advantages these firms enjoy over the public at large,
and even, in sane instances, over options marketmakers .

a. Advantages enjoyed by upstairs firms

The advantages enjoyed by upstairs firms in trading listed options
are similar in many respects to those enjoyed by marketmakers. Upstairs
traders can quickly obtain information from the trading floor (through
the floor brokers employed by their firms) concerning such matters
as order flow, executed transactions and changes in quotations. Like
marketmakers, upstairs firms have information systems which provide
immediate last sale and quotation information. Because traders at upstairs
firms have a direct "wire" i.e. , telephone line, to the floor, they
can react quickly to information by entering or canceling orders through
their floor brokers. In addition, because they are exchange members,
upstairs firms generally incur no commission costs on their transactions.
Finally, like marketmakers, upstairs firms use computer models as an
integral part of their trading, and most brokerage firms actively involved
in options trading have developed proprietary computer programs or modified
existing options pricing models to satisfy their particular needs or
to reflect their specific economic or trading theories.

145

In some respects, upstairs traders enjoy substantial advantages
over marketmakers. The last sale and quotation information available
to them is not limited to the relatively small number of options traded
at one post or the related underlying stocks. Display screens in their
trading rooms allow them to monitor transaction and quotation information
for all listed options and underlying securities. Moreover, upstairs
traders have immediate access to news developments and to input from
their firm's research department regarding fundamental and technical
factors.

In other respects, upstairs firms are at a disadvantage compared
to marketmakers. First, there is a timing disadvantage. The upstairs
firm's instructions must be transmitted to an agent or employee (the
floor broker) who must then try to execute or cancel the order in the
trading crowd. While this process may take only minutes (or less), in
an active market every delay may significantly alter the profitability
of a transaction. 25/

Second, because they carry customer accounts, the net capital re-
quirements imposed on uostairs firms by the Commission are substantially
different from those imposed on marketmakers by the clearing firms which

25/ The timing disadvantage is substantially reduced when the upstairs
firm gives its floor broker certain flexibility to "work" an order,
thereby reducing the need for the upstairs firm to transmit specific
instructions to the trading floor when market conditions change.

146

carry their accounts. This difference has affected the manner in which
upstairs firms trade options, at least to the extent of causing such
firms to forego certain proprietary options trading strategies if the
capital charges are unfavorable. For example, under the existing net
capital rule, certain well-hedged spread transactions (with predefined
risks) result in relatively high capital charges for upstairs traders
compared with the capital charges that would be imposed on marketmakers
with the same positions. Further, the essentially riskless nature of
certain arbitrage transactions is not fully recognized by existing net
capital rules. 26/

Unlike marketmakers, upstairs firms are not given preferred margin
treatment either for their stock or options transactions. Generally
they must meet the full margin requirements for any stock or options
positions they acquire. 27/

In a manner similar to other traders, upstairs firms engage in spreading
and covered and ratio writing strategies although, generally speaking,
such trading is not a function of their particular advantages. As is true

26/ Examples of the impact of the net capital rule on upstairs dealers
employing certain spreading and arbitrage transactions and the
Options Study's recommendations on this subject are contained in
Chapter VII.

27/ Exemptions from Federal Reserve Board margin requirements are

available for upstairs firms when they perform certain dealer func-
tions such as block positioning and third marketmaking, which are
deemed to be beneficial to the overall depth or liquidity of the
market. Dealers who effect transactions in listed securities as
principal off the exchange floor are called third marketmakers.
For a description of block positioners, see infra at 35-39.

147

of marketmakers , however, upstairs firms try to use their advantages
to make money for their proprietary accounts. As discussed below,-
upstairs firms are uniquely situated to employ two types of trading -
arbitrage and block trading - and listed options are often an integral
part of that trading.

b. Arbitrage" trading

Arbitrage transactions involve the simultaneous or nearly simul-
taneous purchase and sale of the same or equivalent securities at
different prices to take advantage of generally small price disparities.
These disparities may arise in the prices quoted for related securities
in different markets on which those securities are traded.

Arbitrageurs do not base their transactions on their opinion of the
underlying stock or the related options class. Since the pricing
inefficiencies are usually very small, only traders who pay little
or no transaction costs will find arbitrage opportunities attractive.
Moreover, these price differences frequently exist only briefly
before they are recognized by market professionals whose transactions
tend to eliminate these differences. 28/ Arbitrage profits can thus
be captured only by those persons who are able to recognize these
disparities, respond instantly, execute orders in different markets,
and are not subject to commission charges.

28/ Upstairs firms frequently utilize computers to monitor, on a real
time basis, last sale and quotation information for all option
stocks and options in order to identify arbitrage opportunities
in options and related underlying stocks.

148

An arbitrane transaction is subject to market risk if all components
of the transaction cannot be effected almost simultaneously, or if the
oarticular market is not sufficiently liquid to permit execution of
the comoonent oarts of the transaction before the price disparity vanishes
Once effected, however, many of these transactions allow the firm to
earn a nrofit without any market risk. 29/

Securities arbitrane adds to the overall liquidity and efficiency
of the marketplace bv introducing additional supply and demand and
bv narrowinq or eliminating pricing inefficiencies. The Commission
has stated that it views arbitraae as "performing a worthwhile
economic role since it seems to equalize the price of a different
security or its eouivalent when traded in different markets." 30/

Uostairs firms use listed options in connection with several
different proprietary arbitrage trading strategies.

(1) Conversion and reverse conversion arbitrage

Arbitrane technioues used by upstairs firms to take advantage
of pricinq inefficiencies between the premium of a call option and
the premium of a put option with an identical strike price and expira-
tion date ("corresponding put") are called conversions and reverse

29/ These so-called riskless arbitrage transactions should be compared
with risk arbitrane transactions, involving mergers or exchange
offers. See infra at 31-33.

30/ Securities Exchange Act Release No. 9950 (January 16, 1973)
(adoption of Rule 19b-2) .

149

conversions. Upstairs firms are almost alone in being able to effect
these strategies because they pay no commissions 31/ on stock or op-
tions transactions, and because they are ideally situated to monitor
the entire options and stock marketplace to identify conversion
and reverse conversion opportunities and to act upon them quickly.
Moreover, as will.be discussed below, in reverse conversion transactions,
access to stock at little or no cost to satisfy short sale delivery
obligations 32/ is a further significant advantage enjoyed by many
upstairs firms (particularly those firms with retail customers)
which cannot be duplicated by other market Drofessionals.

(a) Conversion arbitrage If a call option is overvalued
relative to its corresponding put, conversion arbitrage is used as a
riskless method of capturing the amount by which the premiums are
out of line. The conversion equation is as follows:

DONG STOCK + SHORT CALL + LONG PUT = NO MARKET RISK
If a firm establishes this position (short one call, long one cor-
resoonding put. long 100 shares of underlying stock) and holds the
position to the expiration of the options involved, the position presents
no market risk to the firm and at expiration, regardless of the direction
of movement in the price of the underlying stock, the entire position

31/ The term commission in this context does not include floor brokerage.

32/ When a seller effects a short sale he must deliver the stock
to the purchaser ' s broker within the time required for settle-
ment of the transaction, i.e. , five business days.

150

will be eliminated for the profit which existed when the position was
established. If the calls expire in-the-money, they will be exercised
by the holder and the stock will be delivered to that party; if the
puts expire in-the-money, they will be exercised by the firm which again
will result in the stock being delivered out of the firm. In either
case the out-of-the-money options will expire worthless and the long
stock will be delivered out of the firm pursuant to the exercise of
the in-the-money options.

Since holding the conversion position presents no market risk, the
transaction will produce a profit to the firm if the net proceeds 33/
from selling the call and buying the put exceed the cost of carrying
the stock until the expiration of the options.

For example, assume XYZ stock is trading at 50, and the XYZ
50 calls one month prior to expiration can be sold at 2-1/2 and
the corresponding XYZ 50 puts can be bought at 2. Assume further that
the broker-dealers' cost of money is 9 percent. The cost of
owning 100 shares of XYZ until expiration of the options (1/12
year) will be $5,000 X 9% X 1/12, or $37.50. The options position
(short call + long put) will produce net proceeds of 1/2 point
($50). The profit from a conversion arbitrage transaction can
be shown as follows:

3_3/ In determining the "net proceeds" for this purpose, the intrinsic
value (the in-the-money portion) of either the put or call premium
must be subtracted.

151

Proceeds less Cost = Profit

Sell call + 2-1/2 Interest cost of invest- $12.50

Buy DUt ^_2 ing $5,000 for one month

+ 1/2 or $50. to buy 100 shares of

stock - $37.50

Therefore, $12.50 can be earned without risk each time the position can

be established up to a theoretical maximum of 500 times 34/ or $6,000.

To achieve this maximum profit, however, the arbitrage transaction

would have to be effected 500 times at the assumed prices. In practice,

the arbitrage transactions themselves may bring prices back "into

line" fairly quickly, thus limiting the potential profits.

(b) Reverse conversion arbitrage. If a call is undervalued

relative to its corresponding put, reverse conversion arbitrage

is a riskless method of capturing the amount of this undervaluation.

The reverse conversion equation is as follows:

SHORT STOCK + LONG CALL + SHORT PUT = NO MARKET RISK

If the calls are in-the-money at expiration they will be exercised
by the firm to acquire stock to cover the short stock position. If
the puts are in-the-money they will be exercised by the holder. In
either case stock will be acquired by the firm to cover the short
stock position and the out-of-the-money options will expire worthless.

Reverse conversion arbitrage will thus be profitable whenever
the interest which can be "earned" on the proceeds from the short

34/ Under the position limit rules of the options exchanges, the
combined total of short calls and long puts must not exceed
1,000 contracts since these positions are on the same side of
the market.

152

stock sale exceeds the net cost of the long call, short put position.
Normally the interest earnings are expressed in terms of interest
expense saved since the proceeds of the short stock sale are used
to reduce the broker-dealer's outstanding bank borrowings.

Reverse conversion arbitrage can be demonstrated using the
following example: Assume that XYZ stock is trading at 50 and that
the XYZ calls which expire in one month are undervalued with respect
to puts. The calls can be bought at 2-3/8 and the puts can be sold
at 2-1/8 for a net cost to the firm of $25 (1/4 x 100) to establish
the position. If the firm sells the stock short it can earn $37.50
in interest income for each 100 shares sold ($5000 x 9% x 1/12).
This income is offset by the cost to the firm of $25 to establish the
options position, which gives the firm a net profit of $12.50 (37.50 -
$25) each time the position is established. 35/

Proceeds less Cost = Profit

Interest on $5,000 Buy call + 2-3/8 $12.50

for one month derived Sell put - 2-1/8

from selling 100 + 1/4 or $25

shares short - $37^50

An additional cost, however, must be considered by a firm
evaluating a possible reverse conversion opportunity. This is the

35/ The examples in this section assume that there are no dividends
payable on the underlying stock prior to expiration of the
options involved. The cost of carrying the long stock portion
of the conversion position would be offset to the extent dividends
are received on the stock. The interest generated by the short
stock portion of the reverse conversion position will be offset
by payment of any dividends, since the short seller is responsible
for any dividends paid on the stock which he has borrowed.

153

cost of borrowing stock to deliver in connection with the short
sale. Upstairs firms with a significant retail business, however,
hold a substantial amount of customers' margin securities 36/ which
the firm can use, at no cost, to satisfy short sale delivery require-
ments. In fact, these firms employ reverse conversion arbitrage
as a means of profiting from the availability of these securities.
Firms without access to customers' margin securities are largely
precluded from engaging in reverse conversion arbitrage unless
they are able to borrow stock at little cost.

Conversion and reversion arbitrage opportunities are only available
for those 25 stocks which have both listed put and call options.
( 2 ) Hedged short selling

As a result of their access to customers' margin securities,
some upstairs firms engage in an options trading strategy generally
referred to as a "hedged short sale," which involves selling stock
short and buying deep- in-the-money calls. As described below, this
strategy is not technically a hedging or risk limiting strategy,
but a riskless arbitrage transaction. 37/ Hedged short sales as an

36/ From the broker-dealer's perspective, the dollar amount of

the securities utilized is limited to 140 percent of customers'
margin debits, see 17 CFR 240.15c3-3(a) (4)".

37/ The strategy may, however, be employed as a true hedging strategy
of a bearish nature in the more usual case where the premium paid
for the calls (less any intrinsic value) exceeds the interest on
the short sale proceeds to expiration. This excess could be viewed
as the cost Daid for a position that is the equivalent of owning
a put, where a listed out is not available (but at a greater capital
cost) .

154

arbitrage strategy are effected by upstairs firms only when the
interest on the proceeds of the short sale until the expiration
of the options (less any dividends) exceeds the premium on the calls
less their intrinsic value. Intrinsic value is that amount by which
a stock's price exceeds the exercise price of its call. Near ex-
piration deep- in-the-money calls can frequently be bought at parity
(the price at which the short stock sale can be made less the exercise
price of the calls) and there will be no cost offset to the interest
generated (except dividends where applicable) assuming free access
to stock.

For example, in April, an upstairs firm sells short 1,000 shares
of stock at 30, receiving proceeds of $30,000 from the sale. The in-
terest receivable on the proceeds (assuming an interest rate of 9%
for 1 month) is $225. The firm also buys 10 in-the-money calls (the
May 25s) at 5-1/8. The premium on the call in excess of its intrinsic
value is 1/8 or $125 for 10 contracts. Thus, the profit from this
transaction, if the position is held to expiration, is $225 less $125
or $100.

Because of the need for stock to deliver to the buyer's broker
in connection with the short sale, this strategy is not viable for
broker -dealers (trading on or off the exchange floor) without access
to customers' margin securities. Thus, in the example described above,
if a firm had to pay more than $100 to borrow 1,000 shares of stock to
deliver in connection with the short sale, the transaction would be un-
profitable.

155

(3) Merger or exchange otter arbitrage

Upstairs firms will commit their capital to arbitrage transactions
in mergers, exchange offers, and tender offers when the potential returns
exceed the risks that the proposed takeover will not be consummated.
In this type of arbitrage, the firm buys the securities of the company
being sought (sometimes referred to as the "target" company) and sells
short the securities of the bidding company. The firm expects ultimately
to exchange the target's securities for the bidders' securities to
cover the short position in the bidder's securities. The profit, if
any, comes from the spread between the price which the firm paid for
the "target's" securities, and the price it received for selling short
the bidder's securities. 38/ The firm takes the risk that the merger
or exchange offer will not be consummated, in which case it is left
with a large long position in the "target's" securities, which must
be liquidated, and an equally large short position in the bidding
company's securities, which must be covered. There is an additional
risk that the transaction will be delayed, in which case the interest
cost of carrying the long stock position may exceed the potential
profit.

As noted, the firm's profit lies in the spread between the price
of the bidder's securities and the price of the "target's" securities
as modified by the terms of the exchange offer. For example, if company
A offers to exchange its securities, which are trading at $50, on a

38/ This assumes a one-for-one exchange ratio for the transaction.

156

one-for-one basis for the securities of company B which are trading
at $47 through a merger , an upstairs firm might buy B at $47 and sell
A short at $50. Then, if the merger is consummated, he can exchange
his B stock for A stock and thereby cover his short position in A at a
$3 profit less the interest costs of owning the long position in B stock.

upstairs firms may use listed options instead of stock to limit
their capital commitment in particular merger or exchange offer
arbitrage situations. The strategies most frequently used are selling
calls of the bidder, purchasing puts of the bidder, and purchasing
calls of the "target. The use of listed options in merger or exchange
offer arbitrage is merely an alternative to the broker-dealer's use
of stock. Since the standards governing the selection and maintenance
of underlying securities for listed options generally limit the
subject securities to those of the largest, most well-capitalized
issuers options are not as yet used very frequently in merger or
exchange offer arbitrage. Options are seldom used in such situations
because very few companies with listed options are the subject of
tender offers or exchange offers.

Options are also used by arbitrageurs in connection with certain
tender and exchange offers in which less than all the outstanding
stock of the "target" company is sought by the bidder. In such instances,
the bidding company may reserve the right to accept tendered shares on
a oro rata basis in the event that more shares are tendered than
the bidder desires. An arbitrageur may find that less than all of his

157

tendered snares nave Deen accepted and that ne is left holding a long
stocK position, wnicn, until it is liquidated, will be held at market
risK. In order to reouce tnis risx, arbitrageurs may write call op-
tions equal to the numoer of shares they expect to own in the event
that tne oiler is oversubscribed and not all their shares are accepted.
Tnis is uesiyned to provide a hedge against loss on the long stock pos-
ition e^ual to tne amount of tne premium received from the sale of the
call and is viewed by the aroitrageur as the disposition of the long
stocK position tnrouyh tne sale of a "stock equivalent" if the call
options are m-tne-money .

Tne Commission has proposed amendments to Rule 10b-4 under the
Lxcnanye act. Tnat Rule, generally speaking, is designed to prevent a
person Iran tendering stock he does not own, referred to as "short
tendering." 39/ One proposed amendment to Rule 10b-4 would prevent
a person from tendering stock even if he owns listed options to purchase
tnat stocK unless ne nas irrevocably exercised those options. 40/
Tnis amendment would codify the staff's interpretive position
that ownersnip or a listed call does not constitute ownership of
tne underlying stocK and is designed to prevent the same stock from
oeing tendered Dy tne owner of the option and the owner of the stock.

39/ Securities Exchange Act Release No. 14157 (November 9, 1977).

40/ bee proposed Rule I0o-4(a)(3) (definition of "equivalent security")

40-940 O - 79 - 13

158

( 4 ) Discount options arbitrage
Occasional obvious pricing inefficiencies arise between the
prices of listed options and their underlying securities and present
upstairs traders with the opportunity to profit, such as when the
bid price for a stock is greater than the exercise price of an in-
the-money call on that stock- and its premium. 41/ For example, if
the market for an underlying stock is 16-1/8 bid, 16-1/4 asked, and
an in-the-money call with an exercise price of $15 can be bought
for $1 , the options could be purchased for the dollar, exercised at
a cost of $15 per share of stock (total cost $16), and the stock
sold for 16-1/8. The transaction would result in a profit of 1/8,
less transaction costs. Because commission costs would eliminate
the profit from this type of transaction, only those firms who
pay no commission costs can engage in discount options arbitrage.
Opportunities for this type of transaction generally arise near
the expiration date of an options series, when premiums of the
in-the-money series may have been driven below parity due to the
heavy selling of such options by public customers. These customers
sell, rather than exercise, their options to avoid paying the
commission costs involved in exercising the in-the-money options,
acquiring the stock and selling it in order to liquidate the position

41/ In such instances, the call is said to be selling at a "discount
from parity."

159

c . Block trading

One significant impact of increased institutional investor
participation in the securities markets has been the growth of the
number of transactions involving large quantities or "blocks" of
securities. Because the existing markets may be incapable of ab-
sorbing transactions involving large amounts of a security without
causing significant variations in that security's prevailing market
price, some upstairs broker-dealers have developed the ability to
facilitate customers' block transactions by engaging in block
positioning. The term "block positioner" is generally used to
describe a broker-dealer who facilitates the execution of a block
transaction in an equity security by commit ing its own capital to
purchase a part of a customer's block sale order or by effecting
a short sale (or a sale from inventory) to fill Dart of a customer's
block purchase order. The definition of "marketmaker" in Section 3(a)
(38) of the Exchange Act includes block positioners.

Listed options have afforded block positioners a means of hedging
against the risk of loss from the positions they assume when executing
a block transaction order. Typically, the holder of a block of stock,
usually an institutional investor, "shops" a block by calling certain
upstairs firms to see if they have any interest in the block. Before
a broker-dealer agrees to bid for a block, it first attempts to
dispose of the block by finding the "other side" of the order.

160

It successtul, tne broker-dealer may generate brokerage commissions
trau nandling botn sides ot the transaction on an agency basis
witn no coninitjiient ot capital. If a customer cannot be found
tor some or all ot tne otner side of a block order, however, some
oroker-dealers will commit capital in order to purcnase, for their
own account, sane or all of the stock oeing sold by the customer.

It a broker-dealer does purchase all or part of a block it
generally waits to see how the market is affected by the transaction
wniie at tne same time continuing to look for a customer or customers
tor tne other siae of its position. If the "other side" is found,
or it tne market reestablishes the price level for the stock which
existed prior to the execution of the block, the block positioner
can dispose ot tne position witnout the need to use listed options.
It tne dIock cannot be disposed of satisfactorily, tne firm can
oe suoject to significant market risk. It can limit this risk by
selling listed call options (or buying puts) to hedge against this
loss it it is long tne stock, or by buying calls (or selling puts)
it it is short the stock. 42/

bince prospective sellers initiate a large majority of NYSE
block transactions, 43/ tne most common use of options by a block

42/ Ellectmg options transactions with knowledge of an impending

blocK sale of the underlying stock, but prior to the execution of
and public dissemination of tne fact of that transaction, is
referred to as "front-running a block." Depending upon the cir-
cumstances ot a particular transaction, "shopping" a block may
raise tront-running concerns. See intra at 59-64.

43/ See, e.g. , Institutional Investor Study, Vol. 4 at 1507 (1971).

161

trader is to write calls to hedge the risk of loss from a long stock
position acquired from a customer selling a block. Conceptually,
writing in-the-money calls against a long stock position can be viewed
as analogous to shorting stock against a long stock position to achieve
a net flat position. In this hedged position, a decline in the price
of the stock (resulting in a potential loss) would be offset by a
decline in the call premium (making it cheaper to cover the short call
position) and vice-versa. This allows the firm to largely eliminate mar-
ket risk until the long stock and short call position can be unwound.
Using options in block trading carries a cost for the broker-dealer. It
creates a short call position which, like the long stock position, is sub-
ject to the risk of market movements and which must ultimately be liquidated

Certain broker-dealers will position options blocks 44/ for
customers when they receive options orders too large to be executed
on the options floor. Institutional customers using a buy (stock)
and write (options) strategy generally give both the stock and options
orders to the same broker-dealer because of lower commission costs
and the convenience of placing both orders with one firm. These
orders are frequently entered by the customer as contingency orders,
at a net price, with the execution of the stock order contingent

44/ The CBOE deems an option transaction involving more than 100 con-
tracts to be an option block transaction, see CBOE Educational
Circular No. 23 (October 10, 1978).

162

on the execution of the options order, and vice versa. For example,
if XYZ stock is at 26-5/8 and the XYZ 25 calls are at 3-5/8, a customer
might place the order (buy stock, sell calls) for a net cost of
23 and give the broker-dealer discretion to execute the component
parts of the transaction at prices which result in a net cost of
23. In order to obtain the entire order, broker-dealers sometimes
oosition the options being sold by the customer and thus find themselves
in a hedged position (short stock, long call). Some broker-dealers
engaged in a large institutional options business have suggested
that, if more listed puts were available, they might set up a reverse
conversion position (short stock, long call, short put) from their
short stock, long call position to eliminate, rather than simply
hedge, their risk.

In addition to being used to shift some of the risks associated
with positioning blocks, the listed options market is used by many
upstairs firms to generate brokerage commissions arising from the
purchase or sale of equity blocks by their institutional customers.
A broker-dealer with institutional customers will check the depth
of the market for specified options to determine whether a large
number of calls can be purchased at or near or at a discount from
parity. The firm can offer the underlying stock to the customer
knowing that it can, if necessary, acquire the options as a hedge or,
if an in-the-money series is available, simply acquire the options
for the purpose of exercising and selling the stock to the customer.

163

tor example, a tirm might check the market for specified options
to determine whether a large number of calls can be purchased
at or near parity. If sufficient market depth exists, the firm might
indicate on /uitex 45/ that it is a seller of the underlying stock.
It tne notice on Autex results in an expression of buying interest
uy an institutional customer, tne firm can offer to sell the stock
snort to tne customer knowing tnat it can, if necessary, acquire
tne options as a nedge against the short position or, if an in-the-
honey series is avaiiaole, simply acquire the options for the purpose
ot exercising ana selling the stock to the customer.

d. Creation of Synthetic puts. The limited availability
ot listeu puts nas created sane demand from certain institutional
customers and some retail customers tor so called "synthetic puts."
To create a syntnetic put, a firm can sell XYZ stock short, buy
listed XYZ calls and then sell to a customer an unlisted, non-
standaraized put on XYZ stock. 46/ In other words, the firm sells
to the customer the right to sell XYZ stock to the firm on terms
corresponding to those of the listed call purchased by the firm.

4b/ Autex is primarily a communications system that supplements

tne existing communications systems of upstairs broker-dealers.
Negotiation and execution ot orders are not accomplished through
autex.

4b/ This transaction puts the firm in the same riskless position as
a reverse conversion transaction (short stock, long call, short
put = no marKet risk), see supra at 27. The synthetic put,
nowever, would not be included in the position reports to the
options exchanges and tnus may raise concerns with respect to
exchange position limit rules, bee Chapter IV.

164

The "right" sold to the customer is called a synthetic put since
it is similar to a listed put except that it has been created by
the firm through transactions in the related stock and calls. A
synthetic put has no general marketability and is usually sold to
the firm which created it at a price reflecting the then current
prices for the calls and underlying stock. 47/

In addition, broker-dealers who find themselves already in a
short stock, long call position as a result of their block positioning
activities may have the incentive to solicit orders for synthetic puts,
the sale of which will both eliminate the market risk of the firm's
position and earn commissions. Unless done pursuant to an exemption
from the registration requirements of the Securities Act of 1933, the
offer and sale of a synthetic put, like the offer and sale of any
unregistered security, violates Section 5 of that Act. 48/

47/ A firm repurchasing a synthetic put does so by "unwinding" the

transactions (short stock, long call) which "created" the synthetic
put. Thus, it buys stock and sells calls.

48/ In 1973 the Commission proposed Rule 238 under the Securities
Act of 1933 to exempt put and call options from registration
under that Act, subject to certain conditions. See Securities
Act Release No. 5366 (February 8, 1973) and proposed Rule 9b-2
under the Securities Exchange Act of 1934, see Securities Ex-
change Act Release No. 9994 (February 8, 1973). Neither rule
was adopted by the Commission. More recently, in connection
with the trading of listed options on the Amsterdam Exchange
in Holland, the Commission issued a release stating that "in
the absence of [an effective] registration statement or an
appropriate exemption, the public offer, distribution or sale
of such options in the United States is unlawful." See
Securities Act Release No. 5930 (May 11, 1978).

165

3. INSTITUTIONAL INVESTORS

Institutional money managers increasingly have used options
for adjusting portfolio risk/reward parameters. Many institutional
investors have facilities and equipment through which they receive
financial news and market information in the same manner as market
professionals who are members of exchanges. They can obtain real-time
last sale and quotation information when it is disseminated through
the consolidated transaction reporting system. But, unlike upstairs
firms and marketmakers, institutional customers can generally only
react to reports of news developments and market transactions by
giving an order to a member firm who then transmits the orders to
the floor for execution. 49/ Although this time delay may be only
a few minutes, it nonetheless can constitute a substantial trading
disadvantage vis-a-vis those members, especially in an active market
when prices are changing rapidly.

Because institutions are large customers of broker-dealers, they
can obtain, indirectly, some of the advantages possessed by member
firms. They have sophisticated communications systems which frequently
include direct wires to the trading desks of the broker-dealers
used to execute their orders. In order to formulate their trading
strategies, institutional investors use either their own options

49/ But see. e.g. , CBOE rule 6.70. This rule allows institutions
to send their orders directly to the CBOE floor for handling
by floor brokers.

166

pricing models or can obtain such computer generated information

from broker-dealers. Institutional investors are also offered research

information, ideas regarding trading strategies, and portfolio review

and analysis by member firms. They are also able to negotiate relatively

low commissions for the execution of their orders. Even with low

commissions, however, some trading strategies such as stock and

option arbitrage remain generally out of the reach of most institutional

customers because the pricing inefficiencies upon which these arbitrage

transactions are based are normally smaller than the commissions

they pay.

As certain regulatory impediments have been eliminated by the
Comptroller of the Currency, state insurance regulators and the
Internal Revenue Service, listed options are being used more fre-
quently by regulated institutional investors such as bank trust
departments, insurance companies and investment advisors who manage
employee benefit and welfare plans subject to the Employee Retirement
Income Security Act of 1974 ("ERISA"). 50/

The regulatory environment in which these institutions function,
however, has nonetheless substantially affected the way in which
institutional investors use options. For example, an opinion of
the Comptroller of the Currency permits the banks under its jurisdiction

50/ See generally Pozen, Robert C. , "The Purchase of Protective

Puts by Financial Institutions," The Financial Analysts Journal,
July/August 1978.

167

to write calls against assets under management, and has made covered
call writing the predominant options strategy of bank managed fiduciary
accounts. 51/ The use of options in the management of the stock portfolios
of insurance companies is subject to the requirements of state in-
surance regulators which, to the extent they permit any options
transactions, generally permit covered calls to be written and, to
a lesser extent, the purchase of calls. 52/

Investment advisors, including investment advisory subsidiaries of
banks, are generally under fewer restraints than banks and insurance
companies although, in many instances, the nature of the assets under
management restrict the use of options. For example, investment
advisors who manage pension and welfare fund portfolios subject to the
provisions of ERISA generally do not purchase options or write uncovered
options, since many ERISA accounts have bank trustees and are therefore
subject to the Comptroller of the Currency's limitation to covered
writing transactions. While most registered investment companies
do not buy or sell put or call options, they are not prohibited
from engaging in options transactions by the Investment Company

51/ Trust Banking Circular No. 2 (July 2, 1974). The Comptroller
has not explicitly permitted options purchases or uncovered
writing transactions.

52/ For example, the New York State Department of Insurance regulations
state that "Insurers may not purchase any. . .options [other than
in closing transactions]." Insurance Department of the State
of New York, Regulation No. 72, Section 1744.

168

Act of 1940. 53/ Authority to engage in options transactions can
be obtained by a vote of an investment company's shareholders
and some investment companies have begun to use options as part
of their investment programs. Shares of most of these funds are
being offered to investors seeking income. These funds follow a
buy and write program of purchasing option stocks and writing
calls on a one-for-one basis against these stocks.

The Options Study found, based on its interviews with regulated
institutional investors, that a substantial majority of those in-
stitutional investors using options concentrate on writing fully
covered options, with only a small minority engaging in the purchase
of calls in combination with fixed income securities, or other options
strategies. 54/55/

53/ However, the writing of uncovered options (like the purchases

of futures or forwards in contracts respecting financial instruments)
may raise a question as to whether that activity involves the
issuance of "senior securities" by the investment company within
the Drohibitions of Section 18 of the Investment Company Act
of 1940.

54/ This observation is consistent with a survey conducted for
the AMEX in 1976. This survey found that 79 percent of in-
stitutional investors surveyed concentrated on a covered writing
strategy. See, A Summary of Investors In the Listed Options Markets,
Louis Harris Associates for the American Stock Exchange, Inc.,
May, 1976.

55/ Another category of institutional investor is the investment part-
nership or hedge fund". Comments of marketmakers on the options
exchange floors and broker-dealers who execute stock and options
orders from hedge fund customers suggest that a few large hedge
funds have had a significant impact on options trading and
that their size creates a potential for engaging in questionable
trading practices involving the use of options. The Options
Study was unsuccessful in attempting to voluntarily obtain
trading information from hedge funds. Because they do not report
to the Commission and because the Options Study did not use
subpoenas, it was unable to evaluate stock and options trading
practices by hedge funds.

169

4. SPECIFIC TRADING ABUSES

The discussion above focused primarily on the legitimate ways
in which market professionals use options in connection with their
trading strategies. As noted in the introduction, however, certain
questionable trading practices have also been identified as being
associated with options. These practices, discussed in more detail
below, are proscribed by various sections of the Exchange Act, in-
cluding Sections 9(a)(1), 9(a)(2), 10(a), 10(b), and 11(a).

While the discussion below focuses only on those questionable
practices already identified and known to have occurred, variations
of presently known manipulative stock/options trading may be identified
if the surveillance systems of the self-regulatory organizations
are refined, and if information derived from those systems was
better shared among those organizations. 56/

a. Fictitious trades

When a bona fide options trade is made, a report of the trade
is transmitted to the price reporting system of the exchange on
which the trade occurred. In 1976, the AMEX discovered that some
of its marketmakers were "reporting" trades even though no transactions
had occurred. The reporting of these "non-trades", labelled "fictitious
trades," might have been done for a number of reasons, including:

(1) creating a false or misleading impression of trading activity
in an options class to induce others to purchase or sell
options; or

(2) adjusting or updating the last sale price of an option

to conform to the most recent transaction in the underlying
stock; or

56/ See Chapter IV.

170

(3) altering the closing price of an options position to reduce
a trader's financial obligations to its clearing firm. 57/

After discovering the reporting of fictitious options trades
on its floor in 1976, the AMEX notified the Commission of the problem.
Both the AMEX and the Commission took action against the options
specialists involved. The Commission obtained civil injunctions against
nineteen persons and initiated administrative proceedings against
seventeen persons based on the antifraud (Section 10(b)) and anti-
manipulative (Section 9(a)) provisions of the Exchange Act. 58/

b . Prearranged trading

Prearranged options trades may be done for a number of reasons
including (i) the wish to create a false or misleading appearance
of active trading in the options in order to induce others to purchase
or sell the options, (ii) or for tax purposes, or (iii) to create
the appearance of an active, liquid market for the options. Pre-
arranged trades involve the entry of an order by one person to buy
or sell an option with the knowledge that another person will enter

57/ Clearing firms mark their marketmakers' positions to the market
at the close of trading to determine the current market value
of the marketmakers' positions in order to compute their capital
requirements. See Chapters IV and VII. The Options Study staff
is aware of one instance where a marketmaker effected the last
reported transaction or entered the closing quotation, for almost
an entire month, for the purpose of enhancing the value of his
positions which were "marked-to-the-market" by his clearing firm.

58/ Securities Exchange Act Release No. 13453 (April 19, 1977).
The administrative proceedings were subsequently settled,
Securities Exchange Act Release No. 13797 (July 22, 1977).

171

an order of substantially the same size, at substantially the same
time, and at substantially the same price. A variation of the two-party
prearranged trade is the "wash sale," which describes a transaction
which involves no change in the beneficial ownership of a security.

In 1978, the Commission ordered administrative proceedings
in connection with certain transactions which were effected among
marketmakers at the CBOE. 59/ The Commission's staff alleged that
these marketmakers had executed spread transactions to create losses
for tax purposes. In addition to alleging violations of the antifraud
provisions of the Exchange Act, the Commission also charged that
these transactions were not executed by the marketmaker while he
was acting in the capacity of a bona fide marketmaker as required
by Section 11(a)(1) of the Exchange Act.

c. Chumming

The introduction of multiply traded options, that is, of options
classes listed on more than one exchange, created an environment in

59/ Securities Exchange Act Release No. 14330 (January 3, 1978).
The Commission accepted offers of settlement from all but one
of the respondents and issued its findings and order imposing
remedial sanctions. See Securities Exchange Act Release Nos.
14432 (January 3, 1978); 14431 (January 3, 1978) and 14479
February 6, 1978). The initial decision of the administrative
law judge, which found a violation by the remaining respondent,
was issued on August 22, 1978. The administrative law judge
found that the respondent assisted in options transactions
which he knew or should have known were not bona fide and which
operated as a deceit on the public. This decision is presently
being appealed to the Commission.

172

which options exchanges competed for the order flow for those options
from broker-dealers. Because many brokerage firms automatically route
their small public orders for an option to the options exchange with
the greatest volume of trading in that option, marketmakers of options
exchanges appear to have engaged in prearranged trades, wash sales and
trade reversals among themselves to give the appearance of increased
trading volume in the multiply- traded option for the purpose of inducing
transactions in such options on their options exchanges.

The Commission has stated that this practice, called "chumming,"
may violate the antifraud and antimanipulative provisions of the Act. 60/
The Commission issued a release stating its view that options marketmakers
who may have been "increasing substantially their proprietary trading
in certain dually traded options ... [in order] to induce the purchase
or sale of such dually traded options on their options exchanges instead
of other options exchanges on which the same class is traded" may have
engaged in conduct which violates Section 9 and 10 of the Exchange Act.
In addition, the Commission "cautioned [brokers] against relying solely
on aggregate trading volume reported on [options] exchanges" when deter-
mining the market "to which to route their customers' orders." 61/ To
provide better volume data for use in the future as a measure of "the
relative quality of markets," the Commission "arrange [d] for publication
of reports obtained from exchanges trading options regarding proprietary
options transactions by floor members." 62/

60/ Securities Exchange Act Release No. 13443 (April 5, 1977).

61/ Id.

62/ Id. See also Securities Exchange Act Release No. 13448 (April 15,
1977) and No. 13476 (April 27, 1977).

173

d. Stocky option manipulation
(1) Minimanipulation

A relatively small commitment of capital to an options position can
result in substantial percentage gains if a favorable movement in the
price of the underlying stock causes a corresponding favorable movement
in the price of the option. An attempt to influence the price movement
in a stock to benefit a previously established options position is
referred to as a stock/option manipulation. If the attempted mani-
pulation is of short duration, and involves a relatively slight price
movement in the stock, the effect is often called minimanipulation.
The incentive and opportunity for persons to attempt minimanipulations
is demonstrated by the following series of stock and options transactions
which the Commission staff recently alleged were effected by a marketmaker
on the CBOE. 63/

In July, with IBM stock trading at about 260, a marketmaker was
short approximately 200 July 260 calls. The value of his short position
would be enhanced if, by depressing the price of the stock, the marketmaker
could cause a corresponding drop in the price of the July 260 calls.
To accomplish this goal, the marketmaker purchased 50 deep- in-the-money
calls (the July 240s) and submitted an exercise notice with respect

63/ See Securities Exchange Act Release No. 15269 (October 24, 1978).

40-940 O - 'i

174

to these contracts. 64/ He then increased his short position in the

July 260 call options by selling an additional 100 calls at prices ranging

from 2-7/16 down to 2-1/4. Within a few minutes, he sold 3,900 shares

of the underlying stock acquired through exercise of the July 240 calls

at declining prices ranging from 260-1/2 down to 259-1/2. The options

market quickly reacted to the price decline in the underlying stock

and the July 260 calls declined in price permitting the marketmaker

to profitably cover, within a matter of minutes, a substantial part

of his short position in the July 260 calls at prices ranging from 1-7/8

to 2-1/16. While the dollar profit from closing his short options position

was relatively small (generally less than 1/2 point), the profit reoresented

a oercentage gain of between 20-25 percent on an options position initially

valued at slightly over $70,000. The profit was made despite the slight

transaction costs incurred by the marketmaker to sell the stock, and

the small time premium paid to purchase the deep- in-the-money calls.

Because only a small movement in the price of the underlying stock
will result in substantial percentage gains on the related options,
stock/option minimanipulation may even be accomplished without the

64/ The purchase of the deep- in-the-money calls was used by the market-
maker as an alternative (and inexpensive) method of acquiring the
stock needed to sell in an attempt to depress trie market without
subjecting himself to the restrictive provisions of the Commission's
short sale rules, e.g. , 17 CFR 240.10a-l, or to the risk of being
short both the stock and the options. Under options exchange rules
(or interpretations of such ruies), a holder of an option who submits
an irrevocable exercise notice is deemed to be long the underlying
stock. See, e.g., Interpretation .02 to CBOE Rule 11; CBOE Educational
Circular No. 10 (August, 1975).

175

manipulator engaging in any actual stocK transactions. He might prevent
a move in tne stocx price or move the price merely by placing a large
order just aoove or below tne marxet which could momentarily influence
tne price of the stock in the opposite direction.
(2) Capping and Pegging
Ertecting stocK transactions to depress or prevent a rise in the
price or a stock in oruer to prevent near-tne-money , at-the-money,

or siigntly m-tne-iioney call options from being exercised, and to

protect a previously received premium, is referred to as capping. Similarly,

ettecting stock transactions to prevent a decline in the price of a
stocx, in order to assure that put options written on the stock will
not oe exercised and tnat premiums previously received will be protected

is relerred to as pegging. 'Inese practices are most likely to occur
just oetore expiration of the options series, when the probability of
exercise is nignest. Capping and pegging are forms of minimanipulation.
In one Commission administrative proceeding involving capping, 65/
an options specialist held a large snort position (over 2,800 contracts) 66/
in siigntly ln-tne-money calls. Near expiration, he began to sell substantial
amounts ( approximately 25,000 shares) of tne underlying stock short, generally
witnout noting on nis oruer tickets that the stock was being sold short,

65/ bee, In tne flatter of J. Newman & Co. , et al. (Exchange Act
Release No. 14384), January 17, 1978.

66/ Under the position limit rule of the AMEX, the specialist had
obtained an exemption from the limit of 1,000 contracts on one
sioe ot the rnarxet.

176

thus avoiding the prohibition against short sales on "down ticks" 67/ designed
to prevent the acceleration of a price decline. These sales had the effect
of depressing the market price of the stock. The Commission, in ordering
sanctions against the options specialist, found that these short sales
were timed to satisfy and thus counteract buying pressure which would
drive the price of the stock up and that on some occasions the res-
pondents withdrew their orders or instructed their broker to lower
the limits of their previously entered sell orders when other sellers
appeared in the market. As a result of the specialist's short sales,
the price of the underlying stock declined to the options' strike price
at the expiration of the series and the options specialist did not
receive assignments against his short options position. He thereby
protected the premium income he had earned in establishing the short
call position and also avoided the costs he would have had to incur
to acquire or borrow the underlying stock to satisfy an exercise
notice .

( 3 ) Statutory prohibition of manipulation
Section 9(a)(2) of the Exchange Act makes it unlawful

[t]o effect, alone or with one or more other persons,
a series of transactions in any security registered
on a national securities exchange creating actual or
apparent active trading in such security, or raising
or depressing the price of such security, for the
purpose of inducing the purchase or sale of such
security by others. (Emphasis added.)

67/ See 17 CFR 240.10a-l. The term "down tick" is used to describe a
transaction at a price lower than the last previous transaction.

177

The underscored language has raised questions whether the
antimanipulative prohibitions of Section 9(a)(2) apply to trading
in both an option and the underlying stock in different markets,
referred to as intermarket manipulation.

Rather than rely on Section 9(a)(2), other sections of the
Exchange Act -have been cited as prohibiting intermarket manipulative
trading, including Section 10(b) which prohibits the use of "any
manipulative or deceptive device or contrivance" and Rule 10b-5
thereunder which makes it unlawful "to employ any device, scheme,
or artifice to defraud, ... or to engage in any act, practice
or course of business which operates or would operate as a fraud
or deceit . . . , in connection with the purchase or sale of any
security". 68/

The Commission, for example, has proceeded against intermarket

manipulation on the basis of Rule 10b-5. 69/ Similarly, in an

educational circular on the subject of manipulation, the CBOE took

the position that conduct

will be considered to be in violation of SEC Rule 10b-5 and
CBOE rules if it involves inter-market manipulation, whether
options to stock, stock to options, options series to options
series, etc. 70/

68/ CBOE Education Circular No. 22 (September 15, 1978).

69/ See, In the Matter of J . Newman & Co . , et al. (Exchange Act
Release No. 14384), January 17, 1978.

70/ CBOE Education Circular No. 22 (September 15, 1978).

178

Neither the Commission nor the courts, however, has resolved

the ambiguity in the language of Section 9(a)(2) to make clear that

intermarket manipulation, including stock-options manipulation,

is prohibited by that Section. The Options Study believes such

resolution should be made. Accordingly, the Options Study recommends:

THE COMMISSION SHOULD ISSUE AN INTERPRETIVE
RELEASE OR INITIATE RULEMAKING PROCEEDINGS
SPECIFICALLY TO CLARIFY THAT INTERMARKET
MANIPULATIVE TRADING ACTIVITY INVOLVING OP-
TIONS AND THEIR UNDERLYING SECURITIES MAY
VIOLATE SECTION 9.

(4) Problems of proof and the need for data

In discussing the problem of proof of a manipulative purpose

under Section 9(a), the Commission has stated

since it is impossible to probe into the depths
of a man's mind, it is necessary in the usual
case (that is, absent an admission) that the
findings of manipulative purpose be based on
inferences drawn from circumstantial evidence. 71/

The classic stock manipulation typically involved a security

with a relatively small number of shares held by public customers. A

manipulator would slowly acquire a substantial number of shares over

a fairly extended time period to constrict the supply of the stock.

Then, by creating rumors or favorable recommendations about the

company, or by effecting a small number of carefully timed purchases,

the manipulator would cause a substantial increase in the market

price of the stock. A sharp price rise would induce more investors to

71/ The Federal Corporation, 25 SEC 227, 230 (1947).

179

purchase the stock and this trading activity would cause a further

price rise. When the price had risen sufficiently, the manipulator

would complete the manipulative scheme by selling his securities

at the artificially higher prices for a substantial profit.

Options were often found to be an integral Dart of the classic

manipulative* schemes which occurred in the 1920' s and which gave

rise, in oart, to the introduction of legislation which became the

Exchange Act. In those instances, options (generally granted by

the issuer of the underlying securities) were purchased by the

manipulator to provide him, on exercise, with a ready supply of the

underlying stock, which he could then profitably sell into the

market at the inflated prices resulting from his manipulative

activities. Due to the lack of any secondary trading market for

options, there was no attempt by the manipulator to profit by

selling the ootion itself. The existence of options was used as

circumstantial evidence of the manipulative intent of the manipulator,

In an early case- the Commission stated

The very existence of an option when coupled with
buying on the market by those having an interest in
its exercise is an indication of purpose to raise
the market price, to increase market activity and
thus to distribute profitably the stock covered
by the option. 72/

Modern-day stock/options minimanipulations may be of a quite

different character from traditional stock manipulations, and because

72/ Charles C. Wright, 3 SEC 190, 206 (1938), rev'd on other grounds
sub. nom. Wright v. SEC, 112 F.2d 89 (CA 2, 1940).

180

many legitimate strategies involve stock and options transactions,
manipulative intent cannot be demonstrated simply by showing that
a person held both options and related stock. The manipulator may
have established his options position in the course of legitimate
trading and thereafter decided to effect stock transactions in order
to profit from the options position. Since the minimanipulation
requires only a small change in price of the underlying stock for
a brief period, and because of the present difficulty of precisely
reconstructing the actual timing of related stock and options trans-
actions, 73/ manipulative transactions become very difficult to dis-
tinguish from the legitimate activities of market professionals who
are continuously trading stock and options in quantities sufficient
to affect prices of both securities.

The circumstantial evidence necessary to support a charge of
minimanipulation, moreover, is often difficult to establish because
of the existence of several options series in each class and the likelihood
of a market professional holding long and short positions simultaneously
in different series. Transactions which appear to be done with the
intent of benefiting a position in one options series may be explained
as necessary to carry out some legitimate trading strategy. The trader
may claim, for example, that the apparent manipulative transaction
was part of a legitimate hedging strategy entered into solely to limit

73/ See Chapter IV with respect to the difficulties of reconstructing
stock trading on NYSE.

181

market risk in another series. Indeed, surveillance officials at one
exchange indicated that "if we feel there is a logical explanation
[of questionable stock/options trading] we won't bring the case."
This, of course, is not dispositive of whether there has, in fact,
been a manipulation.

The following example of possible minimanipulation demonstrates
a situation in which a trade may be either a manipulation or a
legitimate hedging transaction, depending upon the actual intent
of the trader. A firm's proprietary account was long 147 July 45 call
options, short 167 July 50 call options and short 3,400 shares of the
underlying stock. The firm sold 10,000 shares of stock at 49-7/8 and
50 and then bought 141 July 50 calls to substantially close its short
options position. While the stock sales may have been part of a manipula-
tion to permit the firm to close out the short position in the July
50 series at a favorable price, the firm said its short stock sales
were designed to hedge the long position in the July 45s against a
price decline.

Because of the difficulty in proving alleged minimanipulations,
and the absence of well-defined legal standards in this area, it appears
desirable to examine stock/option trading patterns in greater detail
than has been possible for the Options Study and to determine if certain
trading patterns should be prohibited by rules adopted by the self-
regulatory organizations or by the Commission.

182

Proscriptive rules in this area should be tailored to avoid
unnecessary impact upon legitimate trading activity. The Options
Study understands that the NYSE and options exchanges have agreed
to exchange information which will provide an integrated data
base of stock and options transactions. Such a data base is essential
to a proper analysis of stock and option trading patterns. This
information can be used to determine the need for and the exact
nature of any rules to regulate patterns of related stock and option
trading. In addition, the self-regulatory organizations have
collected new information which may help the Commission and the self-
regulatory organizations to identify trading patterns that may
be appropriate subjects of antimanipulative rules. Accordingly,
the Options Study recommends:

THE SELF-REGULATORY ORGANIZATIONS SHOULD USE THE INTEGRATED
SURVEILLANCE DATA BASE THAT THEY ARE ESTABLISHING FOR STOCK
AND OPTIONS TRADING TO DETECT UNLAWFUL TRADING ACTIVITIES
AND CONDUCT APPROPRIATE ENFORCEMENT ACTIONS AND TO IDENTIFY
PATTERNS OF STOCK AND OPTIONS TRADING THAT SHOULD BE REGULATED
OR PROHIBITED. THE COMMISSION AND THE SELF-REGULATORY ORGANIZATIONS
SHOULD WORK TOGETHER TO ESTABLISH PRIORITIES FOR THESE STUDIES
AND THE SELF-REGULATORY ORGANIZATIONS SHOULD REGULARLY REPORT
THE RESULTS OF THE STUDIES THAT THEY CONDUCT TO THE COMMISSION.

Additionally, the Options Study recommends:

THE DIVISION OF MARKET REGULATION SHOULD OBTAIN AND REVIEW
ALL INSTANCES OF OPTION AND STOCK TRADING WHICH ARE OR HAVE
BEEN THE SUBJECT OF INFORMAL OR FORMAL INVESTIGATIONS BY THE
SELF-REGULATORY ORGANIZATIONS. THE DIVISION OF MARKET REGULATION
SHOULD REVIEW THIS DATA WITH A VIEW TOWARD PROPOSING ANTI-
MANIPULATIVE OPTIONS AND STOCK TRADING RULES, WHERE APPROPRIATE.

183

e . Front-running

The leverage offered by options, which permits substantial percentage
gains on a small capital investment, and the existence of a liquid market
for options have created new opportunities for profitable options trading
based on non-public market information. One method of taking advantage
of this information is "front-running1 which the Commission has defined
as the practice of trading a security while in possession of unreported
information concerning a block transaction in the same or related
security." 74/ The Commission has stated that such conduct constitutes
an unfair use of non-public market information and is prohibited,
at a minimum, by exchange rules which prohibit conduct inconsistent
with just and equitable principles of trade.

The following is an example of front- running. A block positioner
obtains market information concerning a potential block transaction
in the normal course of his business as a result of an institutional
customer's inquiry concerning a contemplated sale of stock. If a
block positioner is aware of a forthcoming block sale which will
be reported at less than the current market and writes calls before
the price of the calls reflects the block transaction, he would
receive a greater premium than if he had written those calls after
their price moved to reflect the effect of the block sale on the
price of stock and related options. For example, assume XYZ stock

74/ Securities Exchange Act Release No. 14156, November 19, 1977,
(Letter from George A. Fitzsimmons, Secretary, Securities and
Exchange Commission to Joseph w. Sullivan, President, CBOE).

184

is trading at 50 and a call option with a strike price of 50 and with
one or two months to expiration is trading at 2. Assume further that
a block positioner, knowing that he is going to bid 49 for a block
of 30,000 shares of XYZ stock, sells 300 XYZ 50 calls at 2 and subse-
quently executes the equity block transaction at 49. The purchasers
of the calls, however, would not have paid $2 if they knew that a
block of the underlying stock was going to trade at 49, which would
likely have caused a drop in the price of the option.

While option trading based on such market information may permit
a block positioner to hedge his risk and thus make a better bid to a
customer, it gives the block positioner a market information advantage
over other market participants. Trading based on that market information
is inconsistent with the notion of fair and honest markets and just
and equitable principles of trade. 75/

75/ In the above example, the block positioner was trading on the
basis of his customer's stock orders. It would, of course,
also be possible for a market participant to trade options
after deciding to purchase or sell a substantial amount of
the underlying stock for his own account but before effecting
the stock transactions. The Commission has not yet specifically
considered whether "self -front-running" is inconsistent with
just and equitable principles of trade or the antifraud provisions
of the Exchange Act. Nonetheless, "such behavior on the part
of persons with knowledge of imminent transactions which will
likely affect the price of the derivative security [may constitute]
an unfair use of such knowledge." Securities Exchange Act
Release No. 14156, supra.

185

Although the most obvious instances of front-running occur after
all the terms of the block transaction have been agreed to, front-
running may profitably occur at an earlier time. For example, knowledge
that there is either a buyer or a seller of a block may provide a
front-running opportunity even without definite knowledge of the price
at which the block will trade. Block trades initiated by buyers and
sellers have been found to accompany a change in the market price
of the underlying stock by about one percent upward and downward,
respectively (as measured from the previous close to the close
on the day of the block transaction). 76/ Accordingly, while
the propriety of such transactions can best be evaluated on a case-
by-case basis, it would appear that front-running can and should
be found to have occurred in instances where the firm effecting
the options transactions has sufficient market information concerning
a particular potential block transaction to permit it a material
advantage over other market participants.

76/ Institutional Investor Study, Volume 4, p. 1825. (1971). The

findings of the Institutional Investor Study predate the commence-
ment of listed option trading. Listed option trading may have
reduced somewhat the amount of price movement associated with
stock transactions in underlying stocks because of the ability
of block positioners to reduce risk by using options, although
no conclusive evidence is yet available.

186

Broker-dealers follow disparate practices regarding their treatment
of front-running. After the CBOE filed its proposed front-running rule
in 1976, 77/ some firms adopted " in-house" rules (generally unwritten)
prohibiting front-running. These rules vary as to the timing of the
option transaction relative to the dissemination of information regarding
the stock transaction, the method of disseminating the information
regarding an impending block transaction, the definition of a block,
and the price of the block in relation to the current market for the stock,
This lack of uniformity highlights the need for a regulatory pro-
hibition against front-running which applies the same standards
to all market participants.

To date no disciplinary actions have been completed by any options
exchange in the area of front-running, although instances of possible
front-running have been detected by the exchanges through their existing
surveillance programs. Inaction by some self-regulatory organizations
seems to have been either a result of a difference of opinion regarding
the unfairness of front-running activities, inadequate exchange rules,
or lack of a precise definition in this area. For example, in the
past the AMEX has not initiated disciplinary actions against its members
when instances of apparent front-running have been detected. Rather,
they have accepted the argument that the option transaction, when ex-
ecuted prior to the block transaction, is an appropriate hedging strategy

77/ Securities Exchange Act Release No. 12400 (May 3, 1976).

187

Dj tne uIock positioner. Tne Ai*lLX, nowever, has recently revised
its policy on tne subject of front-running and no longer views the
neaging argument as a valid rationale for a members' front-running
conduct. Mitnougn its oy-laws prohibit conduct which is inconsistent
witn just and equitaole principles of trade, 78/ the PHLX, prior
to tne Commission's release in Novemoer, 1977, 79/ failed to proceed
against front-running on tne tneory that its rules only prohibit
memoers' trading based on non-puolic market information obtained
on tne tloor bit/ and tne marxet information regarding a pending
oiocK is lnvariaoly obtained upstairs as a result of an institutional
customer's inquiry. Tnis rationale, nowever, snould no longer
prevent tne initiation of enforcement procedings in the area of
iront-running.

Tne CdUE, which also detected instances of front-running by its
memoers, first attempted to proceed against the practice by rulemaking.
Alter an initial rule tiling with tne Commission, and receipt of the
Commission's consents, tne CbUE witndrew its proposed rule and issued
an educational circular for its members concerning the applicability
to front-running of existing CBOE Rule 4.1, which prohibits conduct
oy members which is inconsistent with just and equitable principles
of trade. 81/ Tne educational circular contains a discussion and

7b/ bee PriLX tsy-Laws, Section 18-7.

79/ bee note 74, supra.

bu/ bee PttlX rule iDlb.

81/ CtXJt, ideational Circular No. 23 (October 10, 1978).

188

examples of conduct involving front-running of blocks that the CBOE
considers to be a violation of its Rule 4.1. The circular also
makes it clear that, while it concentrates on members' proprietary
trading, certain situations, such as where a member passes on non-public
information concerning block transactions to a customer who then trades
on the basis of the information, may also result in a violation of the
CBOE's prohibition against conduct which is inconsistent with just and
equitable principles of trade.

The CBOE circular states that front-running may be based upon
knowledge of less than all the terms of the transaction, if there is
knowledge that all the material terms of the transaction have been or
will be imminently agreed upon. Transactions over 10,000 shares are
conclusively deemed to be blocks and transactions of less than 10,000
shares may be deemed blocks in appropriate cases.

The issuance of an educational circular, such as the CBOE circular,
is an appropriate first step by a self-regulator to provide guidance
for its members on the subject of front-running. Front-running
is an appropriate subject for regulatory attention and definition
in order to put market participants on notice regarding the bounds
of permissible conduct.

Accordingly, the Options Study recommends:

ALL SELF-REGULATORY ORGANIZATIONS SHOULD (1) ISSUE INTERPRETATIONS
OF THEIR RULES TO MAKE CLEAR THAT FRONT-RUNNING IS INCONSISTENT
WITH JUST AND EQUITABLE PRINCIPLES OF TRADE BY ITS MEMBERS
AND, (2) TAKE PROMPT DISCIPLINARY ACTION AGAINST THOSE MEMBERS
WHO HAVE BEEN FOUND TO HAVE ENGAGED IN FRONT-RUNNING.

189

Another method of taking advantage of market information
regarding the underlying stock through transactions in the options
markets is referred to as tape racing, which refers to the trading
of options based on last sale information regarding the underlying
stock before such information has been disseminated over the con-
solidated transaction reporting system. Tape racing is made possible
by inefficiencies in the system by which information regarding
executed trades in underlying stock is transmitted from the floor
of the exchange (generally the NYSE) where the underlying stocks are
traded. Persons who observe trades or have access to last sale
information before it is disseminated may be able to transmit
options orders reflecting that information to the floors of option
exchanges and have such orders executed at favorable prices prior to
the availability of the last sale information on the consolidated
transaction reporting system.

Tape racing appears to have been largely eliminated by speeding
the process of entering transaction information into the consolidated
transaction reporting system and the availability of last sale
information from the NYSE.
5. TRADING RULES

a . Position limit rules

Each options exchange has rules which prohibit any account
from having a position in excess of 1,000 contracts on the same

40-940 O - 79 - 15

190

side of the market. 82/ These rules were adopted by the options exchanges
primarily to minimize manipulative potential and to prevent the accumulation
of large options positions that, if exercised against uncovered writers,
would cause them to buy the underlying stock which would likely affect
the price of the underlying stock. The position limit rules have the
additional effect of limiting the financial exposure of market participants.

The present position limit rules prevent certain larger investors
(primarily institutions) from writing calls or buying puts against
more than 100,000 shares of stock. As a result, the managers of cer-
tain large portfolios do not presently use options because writing
options up to existing position limits does not provide significant
risk limiting caoabilities for such large portfolios. To the ex-
tent that large investors own the stock underlying the options
they write they need not purchase stock to deliver on exercise
of the calls they write or the puts they buy and, therefore, may
not need to effect transactions which will substantially affect
stock prices. As a result, a significant portion of the theory
underlying the position limit rules may not be aDplicable to such
covered investors.

82/ CBOE rule 4.11, which is typical of these rules, prohibits a
member from making an opening transaction for any account in
which it has an interest or for the account of any customer if
the transaction would result in "an aggregate position in excess
of 1,000 option contracts (whether long or short) of the put
class and the call class on the same side of the market covering
the same underlying security."

191

Further, market liquidity may be adversely effected by the
present level of position limits. For example, proprietary option
trading by member firms is limited to the extent that positions in
excess of 1,000 option contracts on any side of the market cannot
be established. Since other proprietary option business may be con-
ducted by the firm at the same time, its position limits may be

used up through different option activities, including hedging
block transactions or arbitrage, thus precluding other options
transactions.

In addition, numerous market participants, including professional
traders, institutional investors, and self-regulatory organizations,
have maintained that the position limit rules should generally be
liberalized or otherwise modified. Further, the ability of some
self-regulatory organizations to grant their marketmakers exceptions
from this rule and the manner and frequency with which exceptions
have been granted, has raised concern that the rule currently has
an unequal impact on members of different self-regulatory organizations
It has been suggested that either the rules be made uniform for all
market participants or that the self-regulatory organizations be
permitted to liberally grant exceptions, especially in instances
where a marketmaker might otherwise violate the rule when fulfilling
his obligation to trade with Dublic customers.

There are a number of approaches which might be followed if
modification or position limit rules is deemed appropriate. Cne

192

would be to completely eliminate such restrictions, thereby per-
mitting option positions to be established without limitation.
Another would be to increase the level of position limits to 2,000
contracts (or some other amount). Alternatively, a sliding scale
position limit rule could be imposed based on the liquidity, trading
volume or price of the underlying security. Different position
limits for hedged positions as opposed to unhedged positions 83/
might be employed on the theory that the former offers less manipulative
potential than the latter. 84/ Finally, consideration could be given
to establishing position limits based on a financial integrity
standard, i.e. , well-capitalized firms might have a lesser restriction
than dealers whose capitalization is below some specified amount.
Accordingly, the Captions Study recommends:

THE DIVISION OF MARKET REGULATION SHOULD UNDERTAKE A COMPLETE
REVIEW OF THE POSITION LIMIT RULES OF THE OPTIONS EXCHANGES.
THIS REVIEW SHOULD INCLUDE: (1) THE POSSIBILITY OF ELIMINATING
POSITION LIMIT RULES, (2) THE FEASIBILITY OF RELAXING POSITION
LIMIT RULES FOR (a) ALL MARKET PARTICIPANTS, (b) FOR ACCOUNTS
WHICH HOLD FULLY PAID, FREELY TRANSFERABLE SECURITIES OR (c) FOR
"HEDGED" POSITIONS, AND (3) WHETHER EXCEPTIONS FROM THE RULES
SHOULD BE GRANTED TO OPTIONS SPECIALISTS AND, IF SO, UNDER
WHAT CIRCUMSTANCES.

83/ Under the rules promulgated by the Commodities Futures Trading
Commission, positions which are deemed to be bona fide hedging
transactions (as defined) are exempted from position limit
rules, see, e.g., 17 CFR 150.1 (c)(i).

84/ The manner in which hedged positions may be established and
eliminated may, however, present questions with respect to
self-front- running. See note 75, supra .

193

b. Restricted options rules

As a result of concerns raised by the Commission shortly after listed
options trading began, the options exchanges adopted so-called "restricted
option rules" which were designed to prevent unwarranted speculation in
deep-out-of-the-money options. The rules prohibit customers and firms
from entering any order for an opening transaction (purchasing or writing)
in any option which is more than $5 out-of-the-money and is trading
for less than $.50 per unit of trading. There are certain exceptions
for covered writing transactions, spreads and marketmaker transactions. 85/

The rules are premised on a belief that as options become deep-out-
of-the-money, they may be improperly sold to public customers who do
not understand the high probability that the options will expire worthless.
In view of its findings, as described in the Chapters V and VT, the
Options Study concurs in these concerns. Nonetheless, as the options
trading markets have expanded, new uses for restricted options have
been developed. Numerous market professionals have advised the Options
Study that currently restricted options could be utilized in a variety
of ways.

For instance, although spreads in which an equal number of options
contracts are purchased and sold are excepted from the restricted
options rules, it is not possible to alter the risk/ reward parameters

85/ See, e.g., CBOE rule 4.17(b) and (c)

194

of such spreads by purchasing or selling additional restricted options.

One commentator, an investment advisor who uses options extensively,

described a spread involving the purchase of an out-of-the-money option

which might be restricted and the sale of a lower strike price option

and stated:

A potentially more rewarding, as well as prudent
strategy would be to buy several of the restricted
options for every single lower strike price option
sold. 86/

Further, the restricted options rules result in pricing inefficiencies

and a loss of liquidity. When a previously unrestricted option becomes

restricted, a holder of such option is left with a limited market because

a large number of potential buyers is barred from the marketplace. This

lack of liquidity has also affected potential buyers. The trader at one

large investment advisor to a number of investment companies told the Options

Study that:

we have occasionally encountered difficulty in
repurchasing a substantial number of [restricted]
options because the dealer is unable to position
such options because of the restricted option
rule. 87/

In addition, a recent study demonstrates that the purchase of deep-

out-of-the-money options with a small portion of an investor's capital

while placing the remainder in money market instruments is a relatively

conservative strategy which would have proved viable over the 12 year

86/ Letter dated September 20, 1978 from F. Martin Koeing, Chase
Investors Management Corporation New York, in response to
Securities Exchange Act Release No. 14854 at 11.

87/ Letter dated August 18, 1978 from Richard F. Palmer, Colonial
Management Associates, Inc. to Kenneth S. Spirer, Assistant
Director, Options Study.

195

period tested. 88/ However, the general strategy of buying calls in
connection with the purchase of money market instruments has been
infrequently used by public investors. 89/

The regulatory concerns underlying the restricted options rules relate
in large part to desires to protect investors who may not fully appreciate
the risk involved in purchasing deep-out-of-the-money options. The Options
Study has made a number of recommendations designed to insure that options
customers will understand the risks of option trading and to improve the
internal procedures of broker-dealers in furtherance of this objective. 90/

The Options Study believes that improvements in the customer suitability

area may, at a future date, allow the elimination of the restricted options

rules. Accordingly, the Options Study recommends:

THE DIVISION OF MARKET REGULATION SHOULD CONSIDER THE
ELIMINATION OF THE RESTRICTED OPTIONS RULES AS SOON AS THE
OVERALL EFFECTIVENESS OF THE OPTIONS STUDY'S SUITABILITY
RECOMMENDATIONS CAN BE EVALUATED.

88/ Merton, Robert C. , Scholes, Myron S., and Glads te in, Mattnew L. ,
"The Returns and Risk of Alternative Call Option Portfolio
Investment Strategies," The Journal of Business, April 1978.

89/ See note 54, supra.

90/ See Chapter II.

CHAPTER IV

SELF-REGULATORY ORGANIZATION SURVEILLANCE

OF THE STANDARDIZED OPTIONS f'ARKETS

I. INTRODUCTION

Market surveillance is the orocess of detect ing trading practices that
mav be inconsistent with the Securities Exchange Act (the "Act"), the
rules and requisitions thereunder, and the rules of self-regulatory
oman izat ions. Self-r^qulatory orqanizations engage in surveillance
activities because, amonq other reasons, the Act assigns them responsi-
bility, subject to Co^nission oversight, for assuring that their markets
are fair, honest, and orderly and that their members comply with the
federal securities laws. Specifically, Section 6(b) of the Act states:

(b) An exchange shall not be registered as a national
securities exchame unless the Commission determines that —

(1) Such exchanqe is so organized and has the capacity
to be able to carrv out the purposes of [the Act] and to
comoly, and ... to enforce compliance by its members and
oersons associated with its members, with the provision of
[the Act] , the rules and regulations thereunder , and rules
of the exchanqe .

(5) The rules of the exchange are designed to prevent fraudulent
and manioulative acts and practices, to promote just and equitable
nrinciDles of trade, to foster cooperation and coordination witn
oersons engaged in regulating . . . securities and, in qeneral, to
orotect investors and the public interest ....

(197)

198

(6) The rules of the exchange provide that . . .
its members and persons associated with its members
shall be aooronriately disciplined for violation of
of the provisions of [the Act] , the rules or regula-
tions thereunder, or the rules of the exchange, by
exnulsion, suspension, limitation of activities,
functions, and oner at ions, fine, censure, being sus-
oended or barred from being associated with a member,
or anv other fitting sanction.

In addition, Section 19 (q) of the Act nrovides:

(a)(1) Everv self-requlatorv organization shall
complv with the provisions of this title, the rules and
regulations thereunder, and its own rules, and . . . absent
reasonable iustif ication or excuse enforce compliance —

(A) in the case of a national securities exchange,
with such orovisions by its members and persons
associated with its members;

(B) in the case of a reqistered securities
association, with such orovisions ... by its
members and oersons associated with its members. . . .

This chanter will discuss the surveillance systems that the self-

reoulatorv orqanizations currentlv use to detect improper trading activities

in the standardized options markets and related trading that may occur in

the markets for their underlving stocks. In particular, it will describe

and analvze the sufficiency of the information that the options exchanges

and the New York Stock Exchange ("NYSE") have available and use for surveillance

nurnoses. It will also evaluate the effectiveness of the techniques

that these exchanqes use to detect potentially improper option and related

stock and ootion tradinq. 1/ The NYSE will be the only stock exchange

_1/ Aopendix Exhibit 1 contains a description of the operations of each
options exchanqe and the NYSE. It focuses on the order execution,
or ice report ina, and trade match and comparison processes. In
addition, this Aopendix Exhibit discusses and describes the specific

(footnote continued on next page)

199

whos<^ surveillance information and techniques will be considered because
option prices are qenerally based upon the prices at which a stock is
tradinq on the NYSE. As a result, stock activity that has the purpose
of benefitinq option positions and option activity designed to benefit
from market information about stock transactions that have not yet occurred
are most likely to involve stock transactions on the NYSE.

The detection of tradinq that may be inconsistent with the federal
securities laws can not, however, be the end of surveillance. When
such trad inn is detectel, it must be investigated to determine whether
the Act or self-requlatory organization rules have been violated.
Moreover, where violative conduct is found, the federal securities laws

(footnote continued)

surveillance technioues that the options exchanges use to detect
tradinq practices that may be inconsistent with the Act or exchange
rules.

Amend ix Exhibits 3-19 contain working papers and investigative reports
that the self-requlatory organizations prepared. Many of tiiese
investiqations have been not concluded, and, as a result, many of them
are nonpublic.

Amendix Exhibit 20 also contains certain nonpublic information.
This Anoendix Exhibit contains (i) a summary of the parameters that
the options exchanges use to define trading activity that will
be scrutinized on a regular basis, (ii) a table summarizing the
number of full- and part-time employees at each options exchange
who Perform surveillance functions, (iii) a table of the expenditures
of each options exchange for surveillance purposes, and (iv) a
table of option volume on each options exchange.

Because much of the information that these Appendix Exhibits contain is
nonpublic, they have been bound separately and will not be publicly
disseminated. Copies have been provided, however, to the Commission,
its staff, and the self-regulatory organizations.

200

and self-regulatorv orqanization rules must be enforced and the conduct
sanctioned with a view toward punishing the violator and deterring future
violations. Recognizing that detection is merely the first step toward
fulfilling its statutory obligations, each options exchange has programs
to invest iqate potentially improper trading practices that its surveillance
system reveals. Each exchange also has programs to enforce compliance
with the law when violations are apparent. This chapter will evaluate
the adecuacy of these investigation and enforcement programs.

rianv of the surveillance techniques described in Appendix Exhibit I
are relativelv new. In fact, the self-regulatory organizations developed
many of these technioues durinq the last year, perhaps as a result of
the concerns that the Commission expressed in October , 1977 regarding
"the present abilitv of the self-regulatory organizations' surveillance
svstems to detect and prevent fraudulent, deceptive, and manipulative
activity, both in options and in underlying securities, in a manner
which is consistent with the maintenance of fair and orderly markets
and the protection of investors and that complies with the requirements
of the Act." 2/ While the self-regulatory organizations have improved
their surveillance programs significantly since October, 1977, tnis chapter
will suqnest additional steps that the self -regulatory organizations and
the Commission should take to improve further self-regulatory organization
surveillance of the standardized options markets.

2/ Securities Exchange Act Release No. 14056 (October 17, 1977).

201

II. METHODOLOGY

The Ootions Study analyzed the surveillance systems of the options
exchanges in three phases. In the first phase, each of the exchanges was
asked to suoolv information concerning, among other things, the ways
in which thcv process and provide for the execution of orders on their
tradinq floors, assemble surveillance information, and conduct surveillance
activities. The information that the exchanges submitted in response
to the Ootions Studv's reouest was used to prepare a summary of the operations
and surveillance svstem of each exchange. The systems of the various
exchanges were then comoared to determine what similarities and differences
miqht exist.

The second ohase consisted of a detailed on-site inspection of each
ootions exchange . The our pose of these inspections was to assure that
the Ootions Studv had a comolete understanding of the surveillance system
of each exchanqe and to determine the extent to which the exchanges were
following the procedures that they had described in response to the Options
Studv's reouest. To conduct these inspections, an inspection outline was
orepared for each exchange. Tne outline identified the data and files
that the Ootions Studv planned to examine, the purpose for examining each
set of files, and the items that each file should have included to constitute
a surveillance inouiry consistent with the procedures that the exchange
had described. After the outlines were prepared, an information request
was sent to each exchange asking that the exchange make available for

202

inspection the data and files specified . Hie inspection outline and in-
formation recuest that were used to inspect the CBOE are included in
an Apnendix Exhibit for illustrative purposes. 3/

The inspections of the exchanqes varied in length. The exchanges
that have the most option volume were aiven the most time. Approximately
200 nerson hours were spent at both the CDOE and the AMEX. Approximately
40 oerson hours were spent at the PSE and PHLX. The MSE inspection took
annroximatelv 16 nerson hours.

Finally, the Options Study inspected the NYSE for the purpose of evaluating
its abilitv to reconstruct stock trading that takes place on its floor.
The Options Studv focused exclusively upon this aspect of the NYSE surveillance
program because effective detection and investigation of related stock and
options tradinq qenerallv reouires that the parties, terms, and time of stock
orders and trades be identified and that stock transactions be sequenced
accordina to the times that they occurred. Approximately 16 person hours
were spent at the NYSE and approximately 10 market reconstructions were
reviewed .

At each exchanqe the Options Studv discussed surveillance techniques
and particular cases with senior exchanqe officials responsible for
surveillance activities. In addition, the Options Study spoke with
staff members at each exchanqe who performed daily surveillance functions

3/ Appendix Exhibit 2. This Appendix Exhibit has been bound together
with the nonpublic Aooendix Exhibits. See n.l, supra.

203

and discussed specific inquiries and investigations with the exchange
staff members who conducted them. The Study did not have sufficient
time or resources, however , to investigate independently questionable
conduct that the exchanqes detected or to review substantial amounts of raw
surveillance information for the purpose of determining whether each exchange
had detected everv instance of potentially improper conduct that may have
occurred in its marketplace.

III. SURVEILLANCE INFORMATION

1. The Sources of Surveillance Information

There are four basic sources of market surveillance information. The
first source is transaction information. Transaction information is
derived from the process of trading. At the options exchanges and the
NYSE, transaction information is generally obtained from documents
oroduced on the trading floor. It contains information identifying the
brokers who have executed a trade, the firms that will clear the trade,
the price at which the parties have agreed to buy and sell, the number
of shares or contracts involved in the transaction, and the time that
the trade was entered into the price reporting system of the exchange.
In addition, transaction information can include bid and ask prices
for a stock or oDtion. Bid price information in a market identifies the
orices at which market participants are willing to buy the securities,

204

and ask Drice information identifies the prices at which market participants
are will inn to sell the securities. The transaction information of the
options exchanges may also contain an indication of the most recent price
at which the stock underlying a class of options was sold.

The second source of surveillance information is derived from the
clearinq process. Clearing involves, amonq other things, the matching
of buv and sell orders after a trade has taken place. This matching
is necessary to assure that, where appropriate, buyers pay for and receive
the securities that they bought and that sellers are paid for and deliver
the securities that they sold. Tb accomplish this matching and bookkeeping,
clearing corporations must know who has traded with whom, at what price,
and in what volume. Accordingly, clearing information identifies at
least the clearing firms that represent the buyers and sellers of securities,
the number of shares or contracts that they have agreed to trade, and
the price at which the trade has occurred. Transactions that are submitted
for clearing late or that are not submitted for clearing at all can
usually be ascertained by comparing clearing information to transaction
information.

The standardized options clearing process contains additional infor-
mation. The Options Clearing Corporation ("OCC") clears all standardized
ootions transactions and is organized differently from the stock clearing
corporations. The most significant difference from an informational
point of view is that the OCC has established three types of accounts

205

in which trades can be cleared: customer, marketmaker , and firm proprietary
accounts. Trades in which member firms act as a dealer or principal,
other than in a marketmakinq capacity, should clear only in firm proprietary
accounts. Trades in which exchanqe members act as marketmakers should clear
in marketmaker accounts. 4/ At each clear inq firm, trades effected on
behalf of customers should clear on an aqgreqate basis in one customer account
Broker-dealer firms that are not members of OCC will carry their transactions
in such customer accounts. As a result of this account system, OCC
clear inn information allows one to determine whether trades were cleared
for a customer, marketmaker, or firm. 5/

In addition, the clear inq process can provide the exchanges with
information identifyinq the buyinq and sell inq broker for each traae
that is cleared, the marketmaker account for which a floor broker executed
a trade, the clear inq firm that will actually clear the trade if that
firm is not a member of the exchanqe, and whether the trade was an openinq
or closina transaction if in a customer or firm proprietary account.
Ooenina transactions are those in which an option position is beinq
increased or established, and closinq transactions are those that reduce
or eliminate an existinq oDtion oosition. Marketmaker accounts are maintained

_4/ See Anoendix Exhibit 1 at on. 1-13 for a discussion of the various
tvoes of on-floor marketmakers. Only on-floor marketmakers may
clear ootion transactions in a marketmaker account.

_V OCC, of course, will clear a trade in the account for which the
trade is reported. As a result, if a firm's trade is reported,
due to error or improper nurpose, as a customer's trade, OCC
may clear the trade in a customer account.

40-940 O - 79 - 16

206

op a not basis and therefore do not indicate whether marketmaker trans-
actions are oneninq or closinq positions.

The third surveillance information source is kept at broker-dealer
firms and relates to the accounts that the firms maintain. Account infor-
mation is reauired to contain the specific identity of the customer,
marketmaker, or firm account for which a trade was done as well
as a record of the tradinq activity and positions of each such account.
A record of the time of entrv and terms of all orders for an account
should be maintained, and the Drice and volume of any executions
that are received should be available. The time of entry is the
time that a firm receives or transmits an order for execution. In
addition, a record of the time at which a reoort of execution was received
should be maintained. Commission rules require that firms keep books
and records which include this information. 6/

Finallv, surveillance information may be obtained from customer
or member complaints, reports bv exchanqc members or employees, companies
that have issued securities, the news media, members of the financial
communitv, and other self-requlatory orqanizations. Exchanqe rules
often reouire members or employees to file reports of unusual tradinq
activitv that thev observe.

Table 1 summarizes the data that can be derived from transaction,
cle^rim, and account information.

6/ 17 CFR 240.17a-3 and 240.17a-4.

207

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208

2. The Organization and Capture of Surveillance Information

a. Transaction Information

The CBOE, PSE, PHLX and MSE capture transaction information from
the trade reoortinq process on the trading floor. The information is
obtained from order or transaction price reporting tickets that these
exchanges collect when trades occur. In general, floor brokers report
their trades on order tickets, and marketmakers report their trades
on transaction or ice reoorting tickets. The information that the tickets
contain is key ounched directly on the trading floor into an exchange
comouter for surveillance and other purposes. This information is used
to oreoare comouter reports of transaction information.

The CBOE transaction report may be used to illustrate the trans-
action information that these options exchanges typically capture. The
CBOE transaction report is called the Market Data Retrieval Listing
("MER"). 7/ The MER identifies the date the trade took place, the options
class and series that was traded, the time the trade was entered into
the CBOE Drice reportinq system, the price to which the parties agreed,
the number of contracts involved in the trade, the buying and selling
brokers, chanqes in the bid and ask prices for the options, the last
sale or ice of the underlyinq stock when the option trade was reported,
and whether the trade was reported out-of-seguence , late, or involved

7/ Exhibit 1 contains examples of MDRs.

209

a spread or straddle which received priority over the book. It should
be noted that the time that a trade is entered into the price reporting
system is not the time that the trade actually occurred. There is
inevitably some delay between the time that the parties agree to trade
in a trading crowd and the time that an order or transaction price
reporting ticket is transmitted to an exchange employee and is key
punched into the price reporting system and the exchange computer. 8/
This delay is not uniform among all orders and may result in the reporting
of some trades in a sequence that is different than the sequence in
which the trades actually occurred.

Transaction information at the AMEX and the NYSE is significantly
less complete than at the CBOE and the other options exchanges. The
Daily Journal Report ("AMEX Journal") is the computerized report of
options transactions that are entered into the price reporting system of
the AMEX. 9/ This report indicates for each option series, in time sequence,
the time that each trade was entered into the price reporting system
of the exchange, the number of contracts traded, and the price at which
the trade occurred. Changes in the bid and ask prices for the options
are also reflected, as is most recent sale price of the underlying
stock. The times that . a Journal indicates that transactions
occurred are more likely to pproximate the time that the parties actually
consummated the trade than the time that trades are entered into the

_8/ See Appendix Exhibit 1 at pp. 43-46.

_9/ A page from the AMEX Journal is shown in Exhibit 2.

210

price reporting system at tne otner options exchanges. This is because
amux trades are entered into its price reporting system by a reporter
stationed in tne trading crowd rather than by exchange employees who
must wait tor members to turn in order or price reporting tickets. For
tne same reason, tne AmEX Journal is likely to reflect more accurately
tne actual sequence of trades. 10/

Information identifying the options transactions in which AMEX
specialists and registered option traders ("ROTs") participated as principal
are addea to tne Journal on the basis of reports that the specialists and
KUi's are required to tile at the end of each trading session. The reports
list, among otner tnings, each specialist or ROT option transaction and
tne specialist's or ROT's report of the time that the trade took place.
Tnese reports are prepared manually and are integrated onto the Journal
oy computer to tne extent that they are legible and the times and volumes
tnat tne reports contain match the times and volumes of reported transactions.
It tnese items do not match, the information on the reports must be reconciled
and added to tne Journal manually. As AMEX volume has increased, it has
oecome necessary to add approximately 80% of all specialist and ROT option
transactions to tne Journal Dy hand. Fifteen clerical people require
a tull day to integrate transactions onto the Journal wnen AMEX trading
volume is normal. Of course, options trades that specialists or ROTs
do not report can not be identified in the Journal.

1U/ See Appendix Exhioit 1 at pp. 21-23.

211

The NYSE Daily Transaction Journal ("NYSE Transaction Journal")
contains even less transaction information than the AilEX Journal. 11/
It lists, in time seouence for each stock, the time that the trade
was entered into the or ice reportinn system, the price that was reported,
and the number of shares traded. Changes in the bid and ask prices
for the stock are also shown. Each hour of trading is contained in
a separate column and the minutes during which trades occurred or oid
or asked Drices were changed are indicated at the right of each
column. Information identifying the trades in which the NYSE specialists
and registered traders and marketmakers participated as principals,
while available on forms that they prepare on a daily basis in accordance
with exchanqe rules, is not routinely integrated onto the Transaction
Journal. Nor are trades that occur by means of the Intermarket Trading
Svstem ("ITS") or the Designated Order Turnaround System ("DOT")
reaularly integrated onto the Journal. 12/

It should be noted that neither the AMEX Journal nor the NYSE
Transaction Journal reqularly identifies the parties that participate
in each trade. This is because these exchanges, unlike the CBOE and
the other options exchanges, do not collect order or transaction
Drice reporting tickets when a trade occurs. Thus, the AMEX and the

11/ A oaqe from an NYSE Transaction Journal is provided in Exhibit 3.
12/ See Aooendix Exhibit 1 at pp. 67-72.

212

MYSE can not capture for routine surveillance purposes the information
that such tickets contain.

b. Clearing Information

The ootions exchanges also create clearing information from the
order and transaction tickets that brokers and marketmakers prepare
on the tradinq floor. On the CBOE*, AMEX, and MSE, floor members usually
submit these tickets to the firms that are going to clear the trades,
and the firms enter the information into their computer systems. 13/
Each clearing firm's trades are then submitted to the exchange where
they took place for purooses of matching and transmittal to OCC for
clearance. On the PSE and PHLX, brokers and marketmakers submit their
tickets to an exchange employee who compares the information that
thev contain. Trades with terms that match are entered into the exchange
computers and sent to OCC. As a result, each options exchange is able
to produce a comouterized report of all the trades that it submits
to OCC.

The CBOE's trade matching and comparison report can be used to
illustrate the information that most options exchange comparison reports
contain. This report is known as a Matched Transaction Listing ("MTL"). 14/
The MTL identifies the two firms that will clear the trade, the brokers
that executed the trade, whether the trade is to clear in a customer,

13/ Appendix Exhibit 1 at p. 26, n.2 describes a different method of
generating clearing information.

14/ An example of an MTL is provided as Exhibit 4.

213

marketnnaker , or firm proprietary account, whether the transaction was

openinq or closinq, the option class and series beinq traded, the number

of contracts traded, and the price to which the parties have aqreed.

If the clear inq firm that will actually clear the trade is not a member

of the exchanqe on which the trade was executed, this firm will be identified

as the "qive-up" firm. AMEX comparison reports contain all of this information

exceot for an identification of the brokers who executed the trade.

This information is not entered into the AMEX clearing process.

Trades that are matched or submitted late are added to the comparison
reports as they are received. Errors and omissions that may occur in
the clear inq process may be corrected by means of position adjustments.
On a dailv basis OCC also provides each options exchange with a computer
tape containinq complete information regarding each transaction that
exchanqe members cleared or adjusted on the previous day. Information
with respect to options positions that were exercised or assigned
is included.

Clear inq information at the NYSE does not contain as much data
as at the options exchanges. The NYSE Reconciliation Clearance Sheets
("NYSE Clear ino Sheets") display only the price and volume of each
transaction and the firms that cleared the trade. 15/ No account infor-
mation is contained because the stock clearing corporations do not

15/ An example of NYSE Reconciliation Clearance Sheets is provided
in Exhibit 5.

214

maintain separate customer, marketmaker, or firm proprietary accounts
for their members as at OCC. The brokers who executed a trade
are not indicated on the stock clearing sheets because this information
is never entered into the clearance process.

c. Account Information

Transaction and clearing information provides an essentially complete
picture of reported marketmaker option trades and positions. In addition,
Daily Position Reoorts that the OCC produces contain, for each account
carried at OCC, the current positions in the account for all option
series, the positions in the account on the previous day, and the
transactions which were cleared since the previous trading session. 16/

With respect to marketmaker stock activities, the AHEX and PHLX
obtain reoorts of all marketmaker stock orders, trades, and positions
on a daily basis. At these exchanges, specialists and ROTs report
this information on forms that the exchanges provide. AMEX Form 958-C
is typical of these forms. 17/ It identifies the specialist or ROT,
his clearing agent, the time that the specialist or ROT reported that
he transmitted each stock order from the AMEX floor for execution,
the type and terms of the order , the number of shares to be bought
or sold, the price and volume of any executions, and the specialist's
or POT's position in the stock at the opening of trading. The form

16/ An OCC Dailv Position Report is shown as Exhibit 6.

17/ An example of AMEX Form 958-C is contained in Exhibit 7.

215

does not contain information concerning the time that all or part
of the order was axecuted or the time that a report of execution was
received.

At the PSE, the marketmaker clearing firms provide similar infor-
mation dailv. PSE Form OTR-1 is used for this purpose. 18/ This form
identifies, bv stock, the time, amount, and limit for each order that
a marketmaker entered, the time and place that the order was executed,
the number of shares that a marketmaker bought or sold during the
dav, end the or ice that he paid or received. The time that the order
was entered is the time that the marketmaker sent the stock order from the
PSE floor for execution, and the time of execution is the time that
an execution reoort was received. Stock position information is not
entered on the form. At the CBOE and MSE, clearing firms provide
dailv reoorts of marketmaker stock trades. These exchanges, however,
obtain marketmaker stock position and unexecuted order information
onlv on a reouest basis.

As a aeneral matter, the time that marketmaker stock orders are
transmitted for execution, the terms of the order, and the time, price,
and volume of any oart of the order that is executed can be obtained
from stock order tickets that the marketmaker 's clearing firm maintains.
Since marketmakers usually enter their stock orders through the firm
that clears their option trades, this firm is generally able to provide

18/ Exhibit 8 is an examole of Form OTR-1.

216

action, and order information. If a market-
er does not enter a stock order throuah the firrr. that clears his

tions at a firm other than his
-iearinq firm, it is oucti -x>re difficult, and may be impossible,
to oc~ er stock activity information.

resoect to customer accounts, the CBOE, AWEX, PSE, PHLX, and
- ~eir members to reoort aggregate long or short positions
of individual customers exceeding 100 contracts in any option class,

in such positions. This reporting requirement
-•ecause OCC maintains only one aggregate account for all
-ion activity at each clearing firm. Such reports, however,
do not disolav customer account trading activity in options, and also
do not >sitions or trading activity in the under -

lvinq ~?ck. Customer account option trading information can presently

c .-^5 only by sending a general request for such information to

Eirn that cleared the customer's options transactions and to the
brokeraqe Eire that e-.tered the customer's options order. Similarly,

r----:: stock tredina information is required z ".ange for

surveillc seSj it mast be obtained by making a general request,

: = , of clearing firms that were active in the stocK
nforaation identifying the accounts that engaged in the stocK trading

217

Members of each options exchange must also file reports with exchanges
if their ootions positions in Droprietary accounts exceed the reporting
thresholds. Their options trading can also be monitored by using
the transaction and clearing information that is normally available.
Because firm proprietary ootions trades reported as such are always
keot in a seoarate account at the OCC and are identified on option
order tickets, they are readily distinguishable in routine surveillance
reports which record this information. If a member firm clears proprietary
ootion orders throuih another firm as a customer, however, resulting
trades would be shown in the customer account of the firm that executed
the orders and not in the oroprietary account of the firm that entered
the orders.

Firm oroorietary stock tradinq, on the other hand, can not generally
be distimuished from customer and marketmaker stock trades on stock
order tickets or in the stock clearing process. This is because the
stock clear inq corporations do not maintain separate accounts for firm
oroorietary stock oositions and because the stock exchanges have not
reouired that order tickets indicate whether a trade is being done
on a orincioal or agency basis. As with customer trading, information
concerninq whether stock trades indicated in the clearing sheets were
effected for a firm proprietary account can only be obtained by making
a reouest of the clear inq firm, on a case-by-case basis, to identify
the party for whom the firm cleared the trade. In addition, firm
oroorietary stock trades that are cleared through another firm in a
customer account are not likely to be discovered by means of a request
sent to the firm that initiated the trades.

Table 2 contains a summary of the transaction and clearing information
that each options exchange captures on a routine basis. The transaction
and clear ina information that the AMEX and NYSE capture with regard to
stock trading is included for comparative Durooses.

218

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3. Conclusions and Recommendations

a. Surveillance Information

An effective market surveillance system must be able to
oroduce essential trading information quickly and accurately. It must
be able to identify the brokers participating in each trade, the firms
clearina the trade, the time that the trade occurred, the price
to which the parties have aqreed, the number of shares or contracts
bouaht and sold, and whether the trade was executed for a customer,
firm, or marketmaker account. Ultimately, the system must be able
to identifv, where aporopriate, the customer that effected a transaction.
In addition, the system must be able to identify Pids, offers, and
orders that were oresent in the tradinq crowd to obtain a complete
oicture of the tradinq environment at a particular time. IP the extent
that this information is readily available, the ease of performing
surveillance functions and designing surveillance programs is increased.
Indeed., without such information, it may not be possible for a self-
requlatory organization to ccmoLy with its statutory obligations.

A surveillance system must also provide its user with a physical
record of the trading that the system monitors. Such a record, often referred
to as an audit trail, is necessary to verify the information that the
svstem oroduces. In particular, documentary evidence must be maintained
if totentiallv imrroper trading practices that the system detects are
to be successfully investigated and resolved.

220

(1) AMEX Surveillance Information and Audit Trail

Each of the exchanqes that permits the trading of standardized
ootions has some ability to identify the parties, reporting time, and
terms of trades that take place on its trading floor. In addition,
each of these exchanges has some ability to obtain a physical record of
those trades. The extent of these abilities, however, varies significantly.

The CBOE, PSE, MSE, and PHLX can identify the buying and selling
brokers, the firms that will clear the trade, the time that the transaction
was entered into the or ice retorting system, the price, the number
of contracts for each trade, and whether the trade was executed for a
customer, firm or marketmaker account. Tnis information is available
the dav after the trades occur. It is customarily obtained from order
and transaction reporting tickets that these exchanges collect when
trades are executed and is key punched into exchange computers from
the tradinq floor. The order and transaction reporting tickets are
keot in case they are needed for surveillance purposes at some later
date.

The AMEX, on the other hand, does not maintain as complete a record of
each trade that occurs on its floor. As a result, it can not verify trade
information by usinq its own records. Moreover, the AMEX can not identify,
on a reqular, automated basis, the brokers that execute each trade or
the firms that will clear the trade. Consequently, the AMEX must resort
to the slow and costly process of manually reconstructing trading from
specialist and ROT reports and from order tickets obtained from member firms

221

to detect and investigate questionable trading practices that may take place

on its floor. The need to use manual processes to reconstruct trading

makes it at best costly and time consuming, and at worst impossible,

for the AMEX to Derform many of the surveillance procedures that the

other options exchanges oerform routinely.

The AMEX has recognized that its surveillance system does not routinely

provide information that is essential to an effective detection program.

It has also recognized that a computer could perform more efficiently and more

completely many of the functions that are now done manually. Moreover,

its recent inability to conduct a conclusive investigation into a series of

possible fictitious trades at one options post on its floor has caused

the AMEX to conclude that it must install a complete audit trail to

be able to monitor its market effectively. In this regard, the AMEX

has stated:

Beginning in late September 1978, a pilot test
of a new trade reporting procedure for options con-
tracts will be conducted during trading hours on the
Floor of the Exchange. This test is being undertaken
to examine new procedures related to the capture and
reporting of trade information and to establish an
exoanded data base of trade information for surveillance
Durooses.

Initially, the pilot test will be conducted at one
post at which a number of moderately active options are
traded. As experience is gained, as members become
more acclimated to the new procedure, and if the test
proves successful, it will be expanded during the first

40-940 O - 79 - 17

222

ouarter of 1979 to include the entire options trading
Floor. 19/

The AMEX "pilot test" beqan on October 2, 1978. The AMEX is
now studying the results and cautiously expanding and modifying
the experiment. These constructive efforts to improve AMEX surveillance
capabilities and to create an adecruate audit trail for options transactions
that take place on the AMEX floor should continue expeditiously.

Accordingly, the Options Study recommends:

TOE AMEX SHOULD ESTABLISH A COMFLETE AUDIT
TRAIL FOR EACH OPTION TRANSACTION THAT
TAKES PLACE ON THE AMEX FLOOR IN ACCORDANCE
WITH THE SCHEDULE THAT THE EXCHANGE PRESENTED.
TOF COMMISSION SHOULD REQUIRE THAT TOE AMEX
SUBMIT A COMPLETE REPORT ON THE RESULTS OF
ITS "PILOT TEST" AS SOON AS THEY ARE AVAILABLE.
THE DIVISION OF MARKET REGULATION SHOULD
FOLLOW TOE PROGRESS OF TOE .AMEX CLOSELY TO
ASSURE THAT THE EXCHANGE ENHANCES THE
CAPABILITIES OF ITS SURVEILLANCE SYSTD4
AND ESTABLISHES A PROPER AUDIT TRAIL AS
QUICKLY AS POSSIBLE. THE DIVISION SHOULD
PRESENT A STATUS REPORT ON THE PROGRESS OF
THE AMEX INITIATIVES TO THE COMMISSION
WITHIN 180 DAYS.

IN ADDITION, EACH SELF-REGULATORY ORGANI-
ZATION SHOULD CONSIDER THE FEASIBILITY OF
IDENTIFYING THE ACTUAL TIME THAT A TRADE IS
EXECUTED TO SUPPLEMENT SURVEILLANCE INFORMATION
THAT IS CURRENTLY CAPTURED.

19/ letter to Richard Teberg, Director, Special Study of the Options
Markets, and Richard Weingarten, Special Counsel, from Robert
Birnbaum, President, American Stock Exchange, dated August 29, 1978.

223

(2) NYSE Surveillance Information and Audit Trail

The NYSE is the primary market for virtually all stocks on which
standardized options are traded. As a result, related stock and options
trading that may be improper often involves stock trading on the NYSE.
NYSE's ability to obtain essential surveillance information quickly and
accurately is thus critical to the ability of all the self-regulatory
organizations to obtain a complete picture, and to conduct effective
surveillance, of the trading of options market participants.

In July, 1963, the Report of the Special Study of Securities Markets

recommended that the NYSE evaluate its plans to modernize and automate

its trading floor procedures "with the view to obtaining and preserving

more market data at the time orders are executed than is presently the

case." 20/ Seeking to implement this recommendation, members of the Commission

staff met with representatives of the NYSE on October 31, 1963 to discuss

"the NYSE's projected system of automation." 21/ On December 10, 1963,

the Commission sent the NYSE a letter summarizing the results of the October

31 meeting and urging the exchange to design and implement, as it proceeded

with its modernization plans, an automated market surveillance system

with a complete audit trail. The Commission stated:

The purpose of the [October 31] meeting was to express the
Commission's interest in obtaining transaction data which might
be accumulated within the capacity of the Exchange's program

20/ Report of Special Study of Securities Markets of the Securities
and Exchange Commission, Part 2, at 358 (1963) (the "Special
Study" ) .

21/ Letter to G. Keith Funs ton, President, New York Stock Exchange,
from Ralph Saul, Director, Division of Trading and Markets, dated
December 10, 1963.

224

and equipment. However, it wouid appear that the present plans
of the Exchange for automation do not now provide for the input
of such data. As a result, the following important market data
with respect to each transaction are apparently not to be obtained:

a. Identity of underlying brokers on both sides (that is,
those whose phone clerks received the orders at the edge
of the floor);

b. Whether the sale was long, short or short-exempt;

c. Whether the specialist acted as agent; and

d. Whether the principal was a specialist, floor trader,
odd-lot dealer, or member-off -floor.

Other desirable data not to be obtained are:

e. Executing brokers (if different from underlying);

f. Covering purchases; and

g. Type of order.

An automated system which accumulated sane of all of the
market data outlined above at the point of execution would . . .
assist in important surveillance purposes, perhaps obviating
or mitigating some of the trading problems which have traditionally
occupied the energies of the Exchange and the Commission. Such
a system could furnish immediately, for particular stocks, reliable
and vital data as to prices, volume and market participants.
Development of such a system affords a possibility for less
restrictive rules than might otherwise be necessary.

We are sure that you also appreciate the contribution which
automated equipment can make to the fulfillment of our mutual
regulatory responsibilities. It is difficult to find any
significant reason for not utilizing this equipment to take
full advantage of its potential for these purposes.

In view of the statutory responsibility of both the Exchange
and the Commission, we urge you to take steps to facilitate obtaining

225

the first 4 items listed above and, if practical, the last 3 as
well. We believe that time is an important factor in the program
and, as requested at tne meeting on October 31, we would appreciate
your specific advice on each of these items at the earliest
possible date. 22/

On December 17, 1963, the NYSE responded. The exchange simply stated
that its "present automation program has not contemplated the capturing of
the additional information detailed in [the Commission's] letter." 23/
The exchange agreed, however, to keep "an open mind concerning the
development of additional systems for the future and . . . welcome [d]
the chance to discuss the problems involved with [the Commission
and the staff]." 24/

The Senate Securities Industry Study of 1973 accurately summarized

the course of events that followed:

For the next three years the SEC continued to urge
and the NYSE continued to resist the prompt development
of an automated . . . surveillance system. Finally in
1966 tne SEC wrote to the NYSE: "We do not believe
that the Exchange, without obtaining such [transaction]
information, can fulfill its self-regulatory responsi-
bilities . . . ." 25/ The NYSE did not respond specifically

22/ Id.

23/ Letter to Ralph S. Saul, Director, Division of Trading and Markets,
from G. Keith Funs ton, President, New York Stock Exchange, dated
December 17, 1963.

24/ Id.

25/ Letter to John R. Bermingham, New York Stock Exchange,

from Irving M. Pollack, Director, Division of Trading and Markets,
dated June 30, 1966.

226

a. Identity of underlying brokers on both sides (that is,
those whose phone clerks received the orders at the edge
of the floor ) ;

b. Whether the sale was long, short or short-exempt;

c. Whether the specialist acted as agent; and

d. Whether the principal was a specialist, floor trader,
odd-lot dealer , or member-of f- floor .

Other desirable data not to be obtained are:

e. Executing brokers (if different from underlying);

f. Cover inq purchases; and
q. Type of order.

An automated system which accumulated some of all of the
market data outlined above at the point of execution would . . .
assist in important surveillance purposes, perhaps obviating
or mitinating some of the trading problems vrtiich have traditionally
occupied the energies of the Exchange and the Commission. Such
a svstem could furnish immediately, for particular stocks, reliable
and vital data as to prices, volume and market participants.
Development of such a system affords a possibility for less
restrictive rules than might otherwise be necessary.

We are sure that you also appreciate the contribution which
automated equipment can make to the fulfillment of our mutual
requlatory responsibilities. It is difficult to find any
sionificant reason for not utilizinq this equipment to take
full advantaqe of its potential for these purposes.

In view of the statutory responsibility of both the Exchange
and the Commission, we urge you to take steps to facilitate obtaining
the first 4 items listed above and, if practical, the last 3 as
well. We believe that time is an important factor in the program

227

and, as reouested at the meeting on October 31, we would appreciate
your soecific advice on each of these items at the earliest
possible date. 22/

Ch December 17, 1963, the NYSE responded. The exchange simply stated
that its "present automation orogram has not contemplated the capturing of
the additional information detailed in [the Commission's] letter." 23/
The exchanqe aqreed, however, to keeD "an open mind concerning the
development of additional systems for the future and . . . welcome [d]
the chance to discuss the problems involved with [the Commission
and the staff 1 ." 24/

The Senate Securities Industry Study of 1973 accurately summarized

the course of events that followed:

For the next three years the SEC continued to urge
and the NYSE continued to resist the prompt development
of an automated . . . surveillance system. Finally in
1966 the SEC wrote to the NYSE: "We do not believe
that the Exchanqe, without obtaining such [transaction]
information, can fulfill its self-regulatory responsi-
bilities . . . ." 25/ The NYSE did not respond specifically

22/ Id.

23/ Letter to Raloh S. Saul, Director, Division of Trading and Markets,
from G. Keith Funston, President, New York Stock Exchange, dated
December 17, 1963.

24/ Id.

25/ Letter to John R. Bermingham, New York Stock Exchange,

from Irvinq M. Pollack, Director, Division of Trading and Markets,
dated June 30, 1966.

228

to this assertion but stated once aqain: "The exchange
would maintain an open mind as to the development of
additional svstems which may be able to capture such
information." 26/

The SEC continued to raise the issue of automating . . .
surveillance with the NYSE during 1967. The NYSE indicated
that it had nade no progress in this area but that it would
keen the SEC informed on the status of its automation programs. 27/
The matter appears to have been dropped at that point. 28/

Althouqh more than 15 years 'have passed since the Special Study

made its recommendations, the NYSE has not yet implemented an automated

market surveillance svstem or an adequate audit trail. The exchange

still does not have the ability to identify, on a routine, automated

basis, the oarticioants in each trade on its floor. Nor does the

exchanqe vet maintain a record, collected at the time that orders are

executed, which indicates the parties, the execution or reporting

tine, and the terms of each trade. While the Options Study has not

examined or analvzed the NYSE surveillance system as a whole, the

lack of such essential surveillance information raises a substantial

concern, as the Commission suggested in 1963 and in 1966, regarding

26/ Letter to Irvina M. Pollack, Director, Division of Trading and
Markets, from John R. Bermingham, New York Stock Exchange,
dated Auqust 8, 1966.

27/ SFC Memorandum of Conference between NYSE and SEC Officials, dated
June 19, 1967.

28/ Reoort of the Subcommittee on Securities of the Committee on Banking
Housing and Urban Affairs, Securities Industry Study, 93d Cong.,
1st Sess. 184 (1973).

229

whether the exchame has the ability to fulfill its statutory responsi-
bilities on a daily basis for each stock that is traded on the NYSE
floor. Moreover, desoite the NYSE's recent initiation of a multimillion
dollar "tradinq facilities uoqrade project," the exchange has not
indicated any intention of reqularly obtaining the surveillance information
that it lacks. 29/ In fact, on October 16, 1978, the NYSE stated:

While we are always looking to improve our surveillance
capabilities, it may not be feasible to try to enhance
audit trail capabilities at the point of execution in
the short term, as this may be disruptive to the
execution nrocess with the systems that exist today
since it would reouire adding reporting staff to the
Floor, or burdening reporters with additional
responsibilities. 30/

Accordinglv, the Options Study recommends:

WE COMMISSION SHOULD CONDUCT A COMPLETE INSPECTION
OF THE NYSE MARKET SURVEILLANCE SYSTEM TO DETERMINE
WHETHER THF EXCHANGE HAS THE ABILITY TO CARRY OUT
THE PURPOSES OF THE ACT AND TO COMPLY AND ENFORCE
COMPLIANCE BY ITS MEMBERS WITH THE ACT, THE RULES AND
REGULATIONS THEREUNDER, AND NYSE RULES. SPECIFICALLY,
THF INSPECTION SHOULD CONSIDER WHETHER THE NYSE
CAN DETECT, ON A DAILY BASIS AND FOR EACH STOCK
TRADED ON THE NYSE, TRADING PRACTICES THAT MAY BE
INCONSISTENT WITH THE ACT, THE RULES AND REGULATIONS
THEREUNDER, OR EXCHANGE RULES. THE INSPECTION SHOULD
BE CONDUCTED AND COMPLETED AS EXPEDITIOUSLY AS POSSIBLE
AND A COMPLETE REPORT SHOULD BE PRESENTED TO THE
COMMISSION WITHIN SIXTY DAYS AFTER THE COMPLETION
OF THF REVIEW.

29/ Letter to Harold M. Williams, Chairman, Securities and Exchange
Commission, from William M. Batten, Chairman, New York Stock
Exchanqe, dated October 16, 1978.

30/ Id.

230

IN THE EVENT THAT THE INSPECTION REVEALS THAT THE NYSE
CANNOT FULFILL ITS STATUTORY RESPONSIBILITIES ON A
DAILY BASIS, THE COMMISSION SHOULD TAKE APPROPRIATE
REMEDIAL STEPS AND SHOULD SPECIFICALLY CONSIDER REQUIRING,
BY COMMISSION RULE, THAT THE EXCHANGE COLLECT AND
MAINTAIN ESSENTIAL SURVEILLANCE INFORMATION.

(3) Stock Market Reconstruction

Market reconstruction is the orocess of identifying the parties
to a series of transactions, the time and sequence of the transactions,
and the or ice and number of shares or contracts involved. It may
also involve the identification of the buying and selling interest
in a security at a particular time. The purpose of a reconstruction
is usuallv to determine the effect that particular transactions
or orders miaht have had on the market for the security being analyzed.

The NYSE has stock trading information at its disposal for
conducting stock market reconstructions that exceeds the information
available to anv other self-regulatory organization. Using its Daily
Transaction Journal, specialist and registered marketmaker and trader
transaction reports, sheets from the specialist's limit order book,
confirmation stubs, dailv clearing sheets, ITS and DOT Journals,
and order tickets obtained from member firms, the NYSE can usually
identify the brokers, dealers, and clearing firms who participate
in a particular trade, the time that orders enter and leave the floor,
the time that trades are entered into the price reporting system,
and the price and volume of each transaction. Some of these information

231

sources also contain information concerninq stock orders that were
oresent on the tradinq floor but that were not executed during a particular
tradinq session. The NYSE reconstruction process, however , is still largely
manual and, as a result, -is costly and time consuming. In addition, the
absence of an audit trail at the NYSE may make it difficult, if not
impossible, to investigate ootentially imtxoper trading practices in
particular cases because the exchange may be unable to determine
definitively the oarties to transactions that may be under consideration.

To help reconstruct option marketmaker stock trading, each options
exchanqe obtains reports of the stock transactions of its marketmakers
on a dailv basis. The CBOE, MSE, and PSE obtain this information from
the firms that clear their marketmakers1 trades, and the AMEX and
PHLX relv primarily upon stock activity reports that they require
their specialists and RCTs to file. Using this information and obtaining
order tickets from the clearing firms if necessary, each options exchange
is able to determine the time that each marketmaker stock order was
transmitted for execution, the amount of the order and its type, the
time that it was reported as executed and the number of shares bought
or sold. With this information and the NYSE Fitch Sheets, which
are oubliclv available and contain the time that trades of stocks listed
on the NYSE were entered into the price reporting system, the price,
and volume for each transaction in a stock in any market, the options

232

exchanges may be able to estimate the impact that a marketmaker ' s stock
orders and transactions may have had upon a stock. Viewing this information
in conjunction with their records of options trading and positions,
the options exchanges can generally conduct effective inquiries and
investigations into related activity in stock and options by their market-
makers. Of course, if marketmakers do not clear their stock trades
or carry their stock positions with the firm that clears their options
trades, or if specialists and ROTs do not report their stock trades,
it is more difficult, and may be impossible, for the exchanges to detect
related stock and option trading by marketmakers that might be inconsistent
with the Act or exchange rules. Improvements should be made to assure
that such marketmakers can not evade self -regulatory organization surveil-
lance systems by clearing stock trades or carrying stock positions at
firms other than their option clearing firms.
Accordingly, the Options Study recommends:

THE COMMISSION SHOULD REQUIRE THAT ALL SELF-REGULATORY
ORGANIZATIONS ADOPT RULES REQUIRING ALL REGISTERED
OPTIONS MARKETMAKERS TO REPORT, BY APPROPRIATE MEANS
AND ON A DAILY BASIS: (1) THE TIME THAT EACH STOCK
ORDER FOR THE MARKETMAKER ' S ACCOUNT, OR AN ACCOUNT IN
WHICH HE HAS AN INTEREST, IS TRANSMITTED FOR EXECUTION,
(2) THE TYPE AND TERMS OF EACH ORDER, (3) THE TIME, VOLUME,
AND PRICE OF ANY EXECUTIONS THAT ARE RECEIVED, AND (4) THE
OPENING AND CLOSING STOCK POSITIONS FOR EACH ACCOUNT IN
WHICH THE MARKETMAKER HAS AN INTEREST.

233

THE COMMISSION SHOULD ALSO (1) REQUIRE THAT THE SELF-REGULATORY
ORGANIZATIONS ADOPT RULES REQUIRING ALL REGISTERED MARKET-
MAKERS TO REPORT ALL ACCOUNTS, FOR STOCK AND OPTION TRADING,
IN WHICH THEY HAVE AN INTEREST OR THROUGH WHICH THEY MAY '
ENGAGE IN TRADING ACTIVITIES, AND (2) PROHIBIT MARKETMAKER
TRADING THROUGH ACCOUI7TS OTHER THAN THOSE REPORTED.

(4) Firm Proprietary and Customer Trading Identification

While each of the ootions exchanges has developed methods of routinely
obtaining substantial information concerning the stock and options
activities of their marketmakers, information about related stock
and options trading of customers and the proprietary accounts of member
firms is not readilv available for routine surveillance purposes.
OCC, for example, maintains separate accounts for marketmaker, firm
oroorietarv, and customer options trading. The stock clearing corporations
do not distinguish among such accounts when clearing stock transactions.
In other words, the stock clearing corporations keep one account for
each clear inq firm, and the task of allocating cleared trades among
the various types of accounts is left to the firms. As a result, the
stock clearing sheets that are used to determine who has been active
in a stock reveal onlv the firms that cleared trades and not the accounts,
nor the tyoes of accounts, for which the trades were cleared.

This method of clearing stock transactions makes it necessary
for the options exchanges to send an inouiry to the firms that cleared

234

stock traces each time that it appears that these trades may be related
to options activity. Frequently, however, the options exchanges only
need information concerning the trading of a firm's proprietary account.
In a front-runninq , minimanipulation, capping, or pegging inquiry,
for example, an exchange may know, due to the account information
orovided by OCC, that option trades were done in a firm's proprietary
account and may wish to find out whether the same firm engaged in stock
activity for its own account. A review of the stock clearing sheets
mav show that the firm cleared stock trades that might have some relation-
shio to the option trades, but will not tell the analyst whether the
stock transactions were cleared for the firm's account, for one customer,
or for manv customers. Consequently, a letter of inquiry must be
sent to the firm askim it to identify the accounts that participated
in the stock trades. This process is costly and time consuming for
the options exchanqes and for member firms and does not routinely
provide the exchannes with member firm proprietary stock trading
information ccmoarable to that which is independently obtained for
marketmakers.

The NYSE and SIAC have recently undertaken to determine the
feasibilitv and cost of distinguishing between member firm proprietary
and customer trades in the clearing process. The Options Study has been

235

informed that SIAC is initiatinq a study of this question and that

a report should be available by March 31, 1979. 31/

Accord inqlv, the Options Study recommends:

THE COMMISSION SHOULD REVIEW TOE SIAC REPORT

AS SOON AS IT IS COMPLETED. THE SELF-REGULATORY

ORGANIZATIONS AND THEIR MEMBER FIRMS SHOULD WORK

TO ESTABLISH AN ECONOMICAL METHOD FOR IDENTIFYING

AND DISTINGUISHING MEMBER FIRM PROPRIETARY AND CUSTOMER

STOCK ORDERS AND TRANSACTIONS. IN THE EVENT THAT

THE SELF-REGULATORY ORGANIZATIONS DO NOT DEVISE A

METHOD FOR EASILY IDENTIFYING MEMBER FIRM PROPRIETARY

.AND CUSTOMER TRADING, THE COMMISSION SHOULD CONSIDER

WHETHER IT IS APPROPRIATE TO REQUIRE THAT THEY DO

SO BY COMMISSION RULE.

The reqular availability of information distinquishinq member firm

proorietarv and customer stock tradinq should enhance the ability

of the options exchanqes to monitor related stock and options tradinq

by firm oronrietary accounts. It may also result in cost and time

savings for exchanqes and their members. Further, creatinq a system

that will distinguish between principal and aqency orders and trades

will facilitate comoliance with Section 11(a) of the Act and assure

that self-requlatory oraanizations have the ability to detect

ootential violations of that section. 32/

31/ Letter to Richard Teberq , Director, Special Study of the Options
Markets, from Robert M. Bishoo, Senior Vice-President, New York
Stock Exchanqe, dated September 28, 1978.

32/ See Securities Exchanqe Act Release No. 12055 (January 27, 1976).

Securities Exchanqe Act Release No. 13388 (March 18, 1977); Securities
Exchanqe Act Release No. 14563 (March 14, 1978); Securities Exchange
Act Release No. 14713 (April 27, 1978); and Securities Exchanqe Act
Release No. 14795 (May 24, 1978).

236

(5) Customer Account Identification

Neither OCC nor the stock clearing corporations presently
maintains a record of specific customers for whom stock and options
trades are executed. At OCC, each clearing firm conducting a public
business has a customer account in which all customer options transactions
are cleared, and at the stock clearing corporations all stock transactions
for each firm are cleared in one account. To identify the customers
for whom particular trades were effected, an exchange must ask the clearing
firms which customers effected the trades and must await a response. This
orocess is costly and time consuming for the exchanges and for the member
firms. In addition, firm responses may recruire further inquiries
of other broker-dealers and may not result in a complete picture of
a customer's trading. If a clearing firm clears for another broker-
dealer, for example, the clearing firm may respond to an inquiry asking
about customer trading by providing the name of the broker-dealer
for whom it is clearing. It would then be necessary to send an inquiry
to that broker-dealer to determine the identity of its customer. Moreover,
the response of one broker to a request for information about a customer's
tradinq will not reveal transactions that the customer may have effected
throuqh other brokers and other accounts. Consequently, it may be
extremelv difficult, if not impossible, to detect improper trading practices
or violations of self-regulatory organization rules in which a customer
may engage if the customer trades through separate accounts at multiple
brokers.

237

The Options Study recognizes that customer account information is
maintained in numerous forms at member firms. The Options Study is also
aware that the cost and time that would be necessary to design and implement
a system that would establish a uniform method of identifying customers
and would make complete customer information available for surveillance
ourooses on a routine, automated basis may be substantial.

The availability of customer account information on an automated,
routine basis, however, would substantially improve the ability of the
self-regulatory organizations to detect customer trading that may be
inconsistent with the Act or their rules. Tne time and money that the
self-regulatory organizations and their members expend making and
responding to inouiries about customer trading could be significantly
reduced if the self-regulators were able to determine easily the customer
for whom a trade was executed. A large brokerage firm, for example, may
respond to freauent requests from options exchanges about legitimate
customer trading simply because its customer account at OCC has cleared
trades that might be improper if done by one customer or a group of
customers in concert. Usually, however, the exchanges find that numerous
unrelated customers engaged in the trades. Such inquiries would not
be necessary if an exchange were able to readily ascertain how many
and which customers effected the transactions.

40-940 O - 79 - 11

238

As self-requlatorv orqanizations modernize their trading facilities
and firms modernize their order routing and processing systems, it may
become easier to create a standard format for identifying customers
and obtaininq customer account information for surveillance purposes.
The NYSF and SIAC are currently studying the feasibility and cost of
caoturino customer information in the clearing process, and a full
report is exDected by March 31, 1979. 33/

Accordingly, the Options Study recommends:

THE COMMISSION SHOULD BEGIN TO STUDY THE MOST
APPROPRIATE MEANS OF ESTABLISHING A UNIFORM
METHOD OF IDENTIFYING STOCK AND OPTION CUSTOMERS
ON A ROUTINE, AUTOMATED BASIS. THE COMMISSION
SHOULD REVIEW THE NYSE AND SIAC REPORT ON THIS
SUBJECT AND SHOULD DETERMINE THE STEPS THAT
SHOULD BE TAKEN TO ESTABLISH A UNIFORM ACCOUNT
IDENTIFICATION SYSTEM IN LIGHT OF THE REPORT.

(6) OCC Position Adjustments

Durinq the trade match and comparison processes at the
options exchanaes, errors and omissions may occur when the terms and
oarties to a trade are entered into the computers of the clearing
firms for clearing purposes. To correct these errors and amissions,
clearing members submit position adjustments to the OCC. The adjustments

33/ Letter to Richard Teberg, Director, Special Study of the Options
Markets, from Robert M. Eishop, Senior Vice-President, New York
Stock Exchanqe, dated September 28, 1978.

239

are submitted in the form of purchases and sales and must be matched.
In other words, for every purchase there must be a corresponding sale.
Position adjustments may also occur between two clearing firms if
a customer or marketmaker account is transferred from one firm to
another or if one firm executes and compares trades for another firm
on an exchange of which the first firm is not a member. These
adjustments are referred to as transfer of account and Clearing Member
Trade Agreement ("CMTA") adjustments.

Position adjustments, however, may also be used for improper
DurDoses. Trade reversals, openinq transactions by customers in
restricted ootions, avoidance of the public priority rules, and off-floor
trad inn ^ay be accomDlished by means of such adjustments. An effective
options surveillance system must therefore contain sufficient information
to Permit a self-reoulatory organization to detect position adjustments
that mav have been entered for improper purposes.

At oresent, OCC issues a report each day containing the adjust-
ments that each clear inq firm submits. The report does not identify
the purpose of the adjustment or relate the adjustment to a particular
trade. In fact, OCC does not reouire its members to indicate the
purpose of particular adjustments, and it is difficult to trace some
adjustments to trades because many firms do not reconcile their books
to OCC records on a dailv basis. Instead, they may balance their positions
less freouently and submit one set of adjustments to correct any
discrepancies.

240

The Options Study's inspections revealed varying degrees of
sophistication among the options exchanges with respect to the review
of position adiustments. At the CBOE and PSE, for example, certain
types of adiustments with well-defined characteristics are reviewed.
At the AMEX, on the other hand, Questionnaires are sent on an essentially
random basis to firms that enter large adjustments. These questionnaires
ask the reasons that the adjustments were made. At the PHLX and MSE,
the extent to which position adjustments are reviewed, understood,
and monitored was not apparent. The inspections also demonstrated
that firms are routinelv able to trace most adjustments back to particular
trades when asked and that order tickets containing the errors that
caused the adjustments can generally be provided if requested.

OCC, however, intends to revise its adjustment procedures by the

end of the first ouarter of 1979. OCC plans to make three significant

revisions in the adjustment process and describes these as follows:

The first change which would be accomplished . . .
is the implementation of a separate transfer of account
system which would provide an independent audit trail
for transfers of account as opposed to other types
of adjustments. Under the new transfer of account
system, two sided input will be required. Both the
transferor clearing firm and the transferee clearing
firm must submit documentation to OCC on authorized
Transfer of Account Forms .... No transfer will
be permitted to go through the system unless both
the transferor and the transferee firm agree to
the transfer.

In addition, the transfer system would have
such controls so as to make it impossible to trans-
fer a market-maker position at one clearing firm

241

to a different market-maker account at another firm.
In addition, transfers that do not match on the
first day that incut is submitted to OCC will be
Dendinq for a maximum of five business days, allowing
the two Clear inq Members time to reconcile any errors.
At the end of five days, any oending items which
have been transferred would be dropped from the system
and the Clear inq Members would be reouired to submit
new inout to OCC before the transfer of account could
be accomplished .

Ihe revised system would also change the present
CMTA adjustment procedure. . . . No firm would be
able to submit a CMTA adjustment unless they had a
valid CMTA aqreement on file with OCC. The system
would be desiqned so that unless such an agreement
was on file, any such adjustment would be rejected.
... [In addition,] all CMTA adjustment input documents
would require the Clearing Member to designate the
Exchange on which the transaction occurred and the
date on which the transaction occurred.

Finally, the Position Adjustment Form is also
beinq revised so that a position adjustment may be
effected onlv in tra-cl earing firm; that is, only
open-close and account type errors may be corrected
throuqh the revised position adjustment form. . . .
These adjustments would be submitted as a single
line item input so that both the buy and the sell
side of the adjustment could be clearly related.

In addition, the position adjustment system would
be modified so that each potential open-close, buy-sell
situation would be separately coded and identifiable.
Accord inqly, surveillance reports could and will be
developed with the ability to recall for surveillance
purposes each c ltial adjustment combination. This
system shoulc Participant Exchanges to determine

whether potent. questionable practices may be taking
olace. 34/

34/ Letter to Sheldon Rappaport, Deputy Director, Division of Market

Regulation, from Marc L. Berman , Vice-President and General Counsel
of OCC, dated August 2, 1978.

242

The Options Study believes that implementation of these revisions will
siqnif icantly improve the ability of the options exchanges to detect
improprieties that mav be effected by means of the adjustment process.
By distinauishinq transfers of account and CMTA adjustments from other
adjustments, codinq and identifyinq open-close and buy-sell adjustments,
and oroscribinq adjustments between clearing firms, the potential for
abusinq the adjustment process will be reduced substantially. As
importantly, the ability of the options exchanges to understand and
investiqate particular adjustments should be enhanced.

However, more could be done to reduce the number of adjustments that
firms submit to OCC. Since many adjustments are the result of
illeqible handwritinq and clerical errors in entering information into
the clearing process, the number of adjustments may be further reduced
if OCC were to introduce disincentives to the entry of adjustments.
Reductions might also be accomplished, and the ability of firms and
exchanges to relate adjustments to particular trades enhanced, if the OCC
reouired its member firms to reconcile their accounts to OCC accounts on
a daily basis.

Accordingly, the Options Study recommends:

OCC SHOULD IMPLEMENT THE REVISIONS IN
ADJUSTMENT PROCEDURES THAT IT HAS PROPOSED
*S SCHEDULED. OCC SHOULD ALSO CONSIDER THE
FEASIBILITY OF IMPOSING A SURCHARGE FOR
POSITION ADJUSTMENTS THAT FIRMS EFFECT

243

ABOVE A CERTAIN NUMBER OF CONTRACTS. THE NUM3ER
OF ADJUSTMENTS THAT A FIRM SHOULD BE PERMITTED
WITHOUT THE IMPOSITION OF THE CHARGE SHOULD
BE DETERMINED GIVING FULL CONSIDERATION TO
THE NUMBER OF CONTRACTS THAT THE FIRM REGULARLY
CLEARS. IN ADDITION, CCC SHOULD CONSIDER THE
FEASIBILITY OF REQUIRING ITS MEMBER FIRMS TO
BALANCE THEIR RECORDS TO CCC RECORDS ON A DAILY
BASIS. THE COMMISSION SHOULD REQUIRE CCC TO
STUDY THESE ISSUES AND REPORT ITS CONCLUSIONS AND
RECOMMENDATIONS TO THE DIVISION OF MARKET REGULATION
WITHIN 90 DAYS.

b. Surveillance Techniques

Each options exchanqe monitors its market to detect trading practices
that mav be inconsistent with the Act and its own rules. These exchanges
have developed techniques to detect related option and stock trading
that miqht be manipulative , prearranged and fictitious option trading,
misuse of material market and inside information, and violations of
certain other exchange rules. While the best of the techniques that
have been developed would provide a self-regulatory organization with
a general abilitv to detect such trading practices, improvements must
be made to maximize the effectiveness of the self-regulatory organization
market surveillance.

( 1) Surveillance Techniques and Surveillance Information

First, the surveillance information that is available to each self-
regulatorv organization must be made more complete as recommended in

244

the orevious section. This should improve the ability of the self-
requlatorv orqanizations to reconstruct their markets and the activities
of their members more accurately, more quickly, and more economically
than at present. Further, this should enhance the ability of the self-
requlatory orqanizations to perform surveillance functions without requesting
as much information from members as often as is currently the case.

(2) The Sharing of Surveillance Information and the
Allocation of Requlatory Responsibility

Second, the surveillance data that exist at each self-regulatory
oraanization must be made readily and economically available to other
self-reaulatory organizations that may need such data for regulatory
purposes. Because the trading activities of a member are not necessarily
confined to the marketplaces of which he is a member, and because
standardized options tradinq has increased the opportunities for market
participants to enqaqe in related activities in numerous markets, the
importance of data sharinq and integration has increased.

To conduct surveillance of tradinq practices that involve stock
and options, for example, the options exchanges rely heavily upon
transaction snd clear inq information from the New York Stock Exchange.
To monitor the activities of a member in an option that is traded
on more than one exchanqe, transaction and clear inq data from

245

all exchanqes on which the option is listed must be gathered. At
oresent, however, such information is qenerally available only on
a reouest basis. Perhaps most significantly, the self-regulatory
organizations do not always notify each other and share information
concerninq investigations and studies that they are conducting even
thounh such studies and investigations often involve trading that
took place in more than one market and market participants who are
members of more than one self-regulatory organization. Moreover ,
studies and investiqations may be duplicated, at the expense of the
members, merelv because the self-regulatory organizations do not inform
each other routinely of their activities.

The self-requlatory orqanizations have recognized that they can
enhance their surveillance capabilities and save time and money by
sharinn the surveillance information that each of them possesses,
coordinatinq their requlatory efforts, and formalizing the channels
of communication amonq them. In fact, the options exchanges, the
WSE, the NASD, OCC, and the Boston Stock Exchange (the "Self-
Pequlatorv Conference" or the "Conference") have recently begun the
Drocess of integrating their surveillance and other regulatory systems.
Since Auaust, 1978, these self-requlatory organizations have held
a series of meetinqs which "have focused ucon the need for the creation

246

of an integrated reaulatory system among the self -regulatory organi-
zations which would enhance total industry regulatory capability by
coordinating and interfacing existing regulatory data and programs
through the sharing of available information, improvement of regulatory
techniaues, [and] the allocation of regulatory responsibility. . . ." 35/
The ourpose of the meetings has been to "imrrove [the] overall regulatory
capability of the SRO's," and to "eliminate overlapping efforts which
mav oresentlv exist, to fill existing voids in regulatory programs and
to oromote the interchange of and access to information." 36/ Significantly,
the Conference has acknowledqed that "the establishment of a more fully
inteqrated regulatory system is both necessary and desirable as a means
of establishing more efficient and effective regulation which may be
cost-effective to the industry and achieve minimum standards of regulation
on an industrv-wide basis thus assuring the protection of public
investors." 37/

The Conference divided into subgroups for the purpose of focusing
on SDecific issues. Each subgroup presented a report to the Conference,
and the Conference Dresented a report to the Study. Two sections of

35/ Letter to Richard Teberg, Director, Special Study of the Options
Markets, from the Self -Regulatory Conference, dated October 6,
1978. A copy of this letter is attached as Exhibit 9.

36/ Id.

37/ Id.

247

the Conference Reoort demonstrate significant progress toward the creation

of an integrated surveillance system for stock and options. These

portions of the reoort, dealing with "Interchange of Market Surveillance

Information" and "Allocation of Responsibility," are ouoted at length to

qive a ccmolete view of the steDS that the Conference has taken and

will take. The report states:

I. Interchange of Information

A sub-qrouo was established on interchange of Market Surveillance
information. This body was directed to identify all market surveil-
lance reports and information presently available to each participant
SRO in order to determine which information could be integrated
into other self -regulatory organizations' programs to enhance
existing regulatory efforts with respect to intermarket surveillance.
This sub-group thereafter collected from and furnished to each
participant SRC, including the Cotions Clearing Corporation,
cooies of all option and equity computer print-outs and certain
manually prepared reports (along with explanatory materials
identifying the type of data, format, frequency and purpose)
which are utilized in conducting market surveillance for listed
securities. In addition to disseminating examples of data
base information derived from transaction and clearing streams,
each organization provided copies of reports which identify
activity which exceeds pre-determined parameters during a
trading session.

^fter the analysis of this voluminous information, a better
understanding of the nature of information available was
achieved. There was also a consensus that the sharing of
data bv the various SRO's is both needed and desired. HDwever ,
while certain agreements have been reached, it is yet to be
determined whether all such information will be furnished
routinely or on some other basis.

It is generally agreed that any information interchanged
may be more desirable in a computer readable format rather
than on microfiche or hard copy print -outs for manageability
and flexibility purposes.

248

Further , it was noted that certain data which would be useful
to each organization is presently available on an on-line
basis throuqh . . . systems . . . for collecting and displaying
option information and for stock activity from the last sale
and ouote information transmitted via hiqh speed lines. This
information could be captured with appropriate programming
which is being developed.

After identifying the information available, the participant
SRO's excressed interest in the exchange of market surveillance
information as follows:

a) Reconciliation Clearing Sheets from markets where
securities underlying options are traded.

b) Daily Transaction Journals from all markets where
securities underlying options are traded.

c) Monthly Short Interest Reports by firm from all
markets where securities underlying options are traded,

d) Block trade reports from all markets where securities
and options are traded.

e) Notification of the initiation of investigations and
reviews, as appropriate.

f) Status reDorts on investigations and reviews, as
aooropr iate .

a) Notification of trading halts.

h) Notification of corporate contacts resulting from

unusual trading activity,
i) Exercise/Assignment Listing Reports from OCC.
i) Open Interest Distribution Reports from OCC.
k) Market Data Retrieval Reports and Matched Trade

Li st inn Reports.

Tne eouity exchanaes indicated that they would be responsive
to inouiries by the options exchanges with respect to matters
which could affect trading in underlying securities and options
trading thereon and would make every effort to inform other
appropriate market centers of trading halts.

249

With respect to the interchange of information pertaining

to multiply listed options, we believe that useful data is

currently being disseminated to the options exchanges via

the dailv Ootions Clearing Corporation compliance tape and

that the modifications due to be implemented in the beginning

of 1979 will enhance monitoring capabilities by providing

member transactions in multiply traded classes on other exchanges.

These modifications, as currently envisioned will consist

of each participant SRO receiving the following:

a) All positions, exercises/assignments and
adjustments of their members regardless of
where the options class is listed;

b) All cleared options transactions of their
mar ketmakers/specialists/ registered traders;
and

c) All exercises, assignments, nositions and adjust-
ments of non-members trading in classes which are
solely listed on their exchange.

There is general agreement among the participant SRO's that they are
willina to share information for surveillance purposes subject
to certain specific limitations, i.e. non-member specialist
and narketmaker positions which would be provided on a case-by-
case basis rather than as a matter of routine. It is important
to note that the participant SRO's agree that all information would
be available to other SRO's for specific investigations.

IV. Allocation of Responsibility

We established an allocation of responsibility sub-group to
exnlore the means of identifying and eliminating duplicative
requlatory efforts as well as the measures necessary to improve
requlatory programs. The sub-group was also requested to provide
the means of resolving such overlaps and shortfalls through
the allocation of responsibility for investigation and
enforcement and to assure, as much as Dossible, the uniform
interpretation and application of comparable self -regulatory

250

and Commission rules. The qroup focused on problems involving
-jurisdictional issues where membership in more than one self-
requlatory organization existed and on inter-market trading
activities which transcended individual SRO jurisdictional
boundaries, such as insider trading activities, fraudulent
and manipulative tradinq practices, tape racing, front-running,
exoiration studies and other specific inter-market transactions.

For ourposes of its discussions, the participants determined that
non-member broker-dealers and non-member broker-dealer customers
would be treated as the same type of entity for surveillance
ourposes. It was also determined that where a non-nember (whether
a broker-dealer or customer ) effects a transaction using the
facilities of a member broker-dealer, the matter should be
referred to the SRO that has jurisdiction over that non-member
or to the SEC if a non-broker -dealer customer is involved.

Of course, the ouestions of jurisdiction over a broker-dealer
which is a member of more than one self-regulatory organization
and/or when a security is multiply traded encompass much
broader and complex issues and consequently consumed a significant
portion of the group's efforts. Based upon its discussions,
the qroup agreed to consider the following principles of
allocation:

(1) The surveillance and regulation of specialists, market-
makers and registered floor traders will be retained by
the self-regulatorv organizations of which they are a
member and on which they fulfill such functions.

(2) The gathering of customer and firm information needed in
oursuinq insider trading and manipulation cases shall

be allocated to the primary market in that family of
markets whenever there is a dually traded security.

(3) Whenever an SRO conducting an investigation lacks jurisdiction
over a broker-dealer non-member, the information necessary

to conduct the investigation shall be obtained from
any other self-regulatory organization of which such non-
member is a member .

(4) Expiration Studies - It was agreed that the SRO's would
inform each other when they are preparing to conduct
expiration studies of options vs. stocks in order to prevent

251

a duplication of effort. If two or more self -regulatory
ornanizations have decided to perform a similar study, they
would determine amonq themselves which would conduct the
study; however , where market-makers, specialists and
reqistered floor traders are involved, the self-regulatory
orqanizations of which they are a member shall retain re-
sponsibility for invest iaatinq such matters.

(5) Disciplinary Procedures - Self-regulatory organizations shall
share information while retaining jurisdiction of their own
members; however, where joint members are involved the market
where the violative activity occurred would be responsible
for disciolining the member unless otherwise agreed upon.

(6) Emplovees of SRO's will be made available for testimony
as needed by other SRD's in any case where their
testimony is reouired or where such employees performed
a nortion of an investigation or examination. (The
self-requletorv orqanizations will continue to review
the possibility of reouiring their members to testify
at disciplinary hearings of other self-regulatory
orqanizations which lack jurisdictional authority over
such members. )

To acccmolish our goals, it is anticipated that there will be
further discussion by the participants to allocate additional
responsibilities with respect to matters arising from the inter-
market requlatory Dr obi ems and to further eliminate regulatory
duplication. 38/

Thus, the self-regulatory organizations appear to be making progress

toward achievinn an effective sharing and integration of information

and coordinatina and allocatinq regulatory responsibilities with respect

38/ Id.

252

to market surveillance. The steps that have been taken help to

assure that, as the Congress envisioned, a "more coherent and rational

regulatory structure" in which there would be "an explicit allocation

of regulatory responsibility" will be established. 39/

Accord inqly, the Options Study recommends:

THE COMMISSION SHOULD CLOSELY MONITOR THE EFFORTS
OF THE SELF-REGULATORY ORGANIZATIONS TO SHARE SURVEILLANCE
INFORMATION AND COORDINATE SELF-REGULATORY ACTIVITIES.
THE COMMISSION SHOULD ACKNOWLEDGE BY LETTER THE
FORMATION OF THE CONFERENCE AND SUGGEST THAT THE
USE OF SECTION 17(d)(2) OF THE ACT AND RULE 17d-2
THEREUNDER TO ALLOCATE SURVEILLANCE RESPONSIBILITIES
AMONG THE SELF-REGULATORY ORGANIZATIONS IS APPROPRIATE
AND DESIRABLE. IN ADDITION, THE COMMISSION SHOULD
SEND A REPRESENTATIVE TO FUTURE MEETINGS OF THE
CONFERENCE. THE COMMISSION SHOULD ALSO SEEK TO
COORDINATE ITS OWN SURVEILLANCE OPERATIONS WITH
THOSE OF THE SELF-REGULATORY ORGANIZATIONS.

(3 ) Improving Options Exchange Surveillance Techniques
Third, all of the options exchanges do not use the most sophisticated
techniques available to detect improper trading practices. As Appendix 1
reveals, 40/ each of the options exchanges has its own methods of
conducting surveillance activities, these methods varying in scope and
ouality and often in accordance with the surveillance information that is
available to the exchange. With the sharing of surveillance techniques
and information that should accompany the progress of the Self-Regulatory

39/ S. Rep. No. 94-75, 94th Cong. 1st Sess. 2, 32 (1975).
40/ See Appendix 1 at 79 - 141 .

253

Conference, each of the options exchanges should be able to upgrade its

methods of detecting improper trading practices to assure that it is

usinq the most effective techniques available to the greatest extent

oracticable.

Accordingly, the Options Study recommends:

WHEN CONDUCTING OVERSIGHT INSPECTIONS OF
THE OPTIONS EXCHANGES, THE COMMISSION SHOULD
REVIEW THE SURVEILLANCE TECHNIQUES THAT EACH
OPTIONS EXCHANGE IS USING TO ASSURE THAT
THE MOST EFFECTIVE TECHNIQUES AVAILABLE
ARE BEING EMPLOYED.

(4) Uniform Reporting Requirements

The self-requlatory organizations have suggested on numerous
occasions that uniform standards should be developed and applied on
an industrv-wide basis with regard to transaction and position reporting
reouirements. The Cations Study has considered these proposals and agrees
with their thrust.

The position and transaction reporting rules vary from exchange
to exchanoe. While this situation certainly creates the potential
for disoarate treatment of similarly situated people and entities,
the Ootions Studv does not believe that Commission action is warranted
at this time. In view of the approval of the NASD plan to regulate
the ootions activities of broker -dealers who are NASD members but
who are not members of any exchange 41/ and the cooperative spirit

41/ Securities Exchange Act Release No. 15332 (November 15, 1978).

40-940 O - 79 - 19

254

that the self-requlatory orqanizations have demonstrated recently,
the self-requlators may be able to develop requirements, applicable
to all broker -dealers, for positions and transactions that should
be reported for requlatory purposes. Moreover, because each of
the self-requlatorv organizations inouires into essentially the
same tradinq oractices, it may be feasible to standardize inquiry
forms to facilitate the ability of member firms to respond to self-
reaulatory orqanization requests for information. Such standardi-
zation mav result in time and cost savinqs to the industry,
^ccordinaly, the Options Study recommends:

THE SELF-REGULATORY ORGANIZATIONS SHOULD DEVELOP
STANDARDS FOR MINIMUM POSITION AND TRANSACTION
REPORTING RULES AND STANDARDIZED INQUIRY FORMS.
IN THE EVENT TEAT STANDARDS ARE DEVELOPED AND
SUBMITTED TO THE COMMISSION FOR APPROVAL,
THE COMMISSION SHOULD ACT UPON THEM EXPEDITIOUSLY
.AND ADOPT, WHERE FEASIBLE, RULES TO GOVERN
SECO BROKER-DEALERS WHICH ARE PARALLEL TO
SELF-REGULATORY ORGANIZATION RULES.

IV. INVESTIGATION AND ENFORCEMENT

Each of the options exchanqes has proqrams to investiqate tradinq
oractices that its surveillance system detects and which may be inconsistent
with the Act or exchanqe rules. Each exchanqe also has procedures for

255

r'iscinlinina members that violate the Act or exchange rules. During its
inspections, the Ootions Study reviewed more than 700 investigations, through
various stages of completion, that the exchanges had conducted. More
than 300 case files were examined at the CBOE and more than 175 files
were reviewed at both the AMEX and the PSE. The Options Study also
reviewed more than 20 investigations at the PHLX, MSE surveillance logs
for a two vear oeriod, and more than 25 MSE inquiries into questionable
conduct. On the basis of these records and its inspections, the Options
Study has drawn some general conclusions concerning the thoroughness
and effectiveness of the investiqation and enforcement programs
of each exchanne. 42/

1. The CBOE and PSE

The CECE and PSF maintain generally complete records of each inquiry
or investiqation that they conduct. Records usually contain the
surveillance information that prompted the inouiry, notations evidencing
the steps that the investiqator or analyst took to investigate the
auestionable activity, a memorandum or report indicating the recommended

42/ A samole of the information requests and inspection outlines that
the Ootions Study used to perform these inspections is contained in
Aopendix Exhibit 2.

256

disoosition of the case and the reasons for the recommendation, and
documentation to support the recommended disposition. The ultimate
disoosition of the case is also apparent from the files or from
exchanqe records that indicate the status of open cases, matters
pendinq before disciplinary panels, and decisions that disciplinary
panels have made. The staff investigations at these two exchanges appear
to be generally complete and properly analyzed.

At the CBOE, a permanent committee composed of floor members,
nonfloor members, and a representative of the public reviews each
case that the staff has prepared to determine whether there is probable
cause to believe that a violation occurred. If the committee finds
such probable cause, it will issue a Statement of Charges to the
member that may have committed the violation. The committee will
then hold a hearinq and determine whether a violation took place,
and, if so, how the member should be sanctioned. In general, CBOE members
did not appear reluctant to issue charges against and sanction their
oeers when violations were apparent. Moreover, it appeared that the
CBOE has souqht to use the disciplinary process to establish ethical
and leqal quides for the conduct of the membership.

At the PSE, the staff issues a Statement of Charges each time it is
of the view that a violation may have occurred. The staff issues
charqes routinely unless there are "extenuating circumstances."

257

Once charier are issued, a standing committee of floor and nonfloor
members from both Los Anqeles and San Francisco, or a panel of options
floor members, depending on the nature and severity of the alleged
violation, will receive the charges, conduct any hearing that may
be necessarv, and resolve the matter. While the decisionmaking process
at the PSE appeared slower than at the CBOE, its system of peer review
aoneared to function effectively.

2. The PHLX

The Cotions Study's inspection of the PHLX revealed that much of its
surveillance and investigation was done informally. While it appeared
that the numerous options surveillance reports that the PHLX creates and
receives are reviewed daily to determine whether improper trading
oractices may have occurred, investigation usually consists of telephone
calls, reviews of order tickets and reports, and personal discussions
with members. Ffecords of such inquiries and their results are not generally
maintained .

Because there were no records of informal inquiries and few
investigative case files or disciplinary proceedings to review, it
was difficult for the Cotions Study to ascertain the effectiveness and

258

thorouqhness of PHLX investigation and enforcement programs. The few

files and formal oroceedings that were reviewed, however, were relatively

complete and adecuately evaluated.

Accordinqlv, the Options Study recommends:

THE PHLX SHOULD PROVIDE COMPLETE DOCUMENTATION
WITH RESPECT TO ROUTINE SURVEILLANCE FUNCTIONS
AND INVESTIGATIONS THAT THE EXCHANGE PERFORMS.
SUCH DOCUMENTATION IS NECESSARY TO ASSURE THAT
THE PHLX IS CARRYING OUT ITS STATUTORY RESPONSI-
BILITIES PROPERLY.

3. The AMEX

The American Stock Exchange inspection revealed that trading
oractices that may have been inconsistent with the Act or AMEX rules
were often detected. After detection, potential violations were investi-
qated. Like the CBOE and PSE, the AMEX keeps a record of each case that
it investigates , and AMEX case files generally contain a description of
the trading activity that the surveillance staff considered questionable,
surveillance reports that were used to detect the activity, an explanation
of the steps that were taken to investigate the matter , and the recom-
mendations of the analvst for disposition of the case. Handwritten notes
amonq senior staff members frequently evidenced their review of the case
and participation in its disposition.

The Options Study's inspection of the AMEX, however, caused
the Options Study some concern. Most siqnificantly, a troublesome

259

pattern of case closings was observed. 43/ These case closings
involved susoected min manipulation, capping, or prearranged trading
bv AMEX specialists or ROTs. After the questionable trading was
detected, information concerning the specialist or ROT positions
and activity was obtained, and testimony was taken. The specialist
or ROT who enaaaed in the possibly improper conduct then gave an ex-
planation of the tradinq, and the staff, usually after lengthy internal
discussions, and often with some reluctance, closed the case. Because
the AMEX staff is able to issue a Statement of Charges without working
throuah a committee of members, each case was closed without member
oarticio^tion or review. Frequently, staff memoranda indicated that
the case was beinq closed since "the Exchanqe would probably be
unsuccessful in orosecutinq the matter before a disciplinary panel
[of members]" if the specialist or POT "could offer a reasonable
economic explanation" of his activity.

The Options Studv finds these closing procedures troublesome
for four reasons. First, there is almost always some reasonable

43/ The Options Study has not attempted to determine whether violations
of the Act or AMEX rules occurred in the cases that were reviewed.
Rather, the Ootions Study examined the cases to understand the
extent and thoroughness of AMEX investigations after potential
violations are detected, the standards applied in making the
decision of whether to issue a Statement of Charges to a member,
and the circumstances under which investigations are terminated.

260

explanation for tradinq activity, particularly where stock and numerous
ootions series and classes are beinq traded. At the same time, there
is usually another explanation for the activity which, if true,
would involve a violation of the securities laws. As a result, the
existence of a loqical explanation for tradinq should not alone
determine whether a Statement of Charqes should be issued.

Second, since cases are closed if the staff believes that a
nenel of members will not impose disciplinary sanctions under the
circumstances, the staff effectively sets the standards, both leqal
and ethical, for conduct on the AMEX floor with no member involvement.
Even thouqh manv of the closed cases involved tradinq patterns that
were clearly suspicious, the AMEX membership was never formally
consulted with reqard to whether such tradinq should be permitted
on the exchanae. While the independence of the staff must be main-
tained and the membership need not become involved in each investi-
qation or each determination of whether a Statement of Charqes
should be issued, effective self-requlation requires that the
members of the self-requlatory orqanizations play an active role in
defininq standards to quide their tradinq conduct, particularly
where ethical , rather than leqal , standards are at issue .

Third, AMEX analysis of particular fact situations appeared, in
certain instances, to be less careful and thorouqh than that observed
at the CBOE and PSE. Explanations that were qiven for tradinq activity

261

often should have been subjected to more rigorous analysis, and the
details of cases were too freouently overlooked or considered
unimoortant. Perhaps because the AMEX staff is not required to
oreDare cases formally, either for review after closing or for deter-
minim whether a Statement of Charges should be issued, facts and
leqal amuments did not aDDear to be marshalled and presented as
forcefully or as preciselv as the exchange's responsibility under
the Act reouires.

Finallv, case files revealed a number of instances in which the
AMEX reDortino recuirenents and rules concerning the responsibilities
of members to cooDerate with exchange investigations may have been
violated. In some cases, for example, members did not file reports or
keen records that Commission or AMEX rules require; in other cases,
retorts that were filed were inaccurate. In some instances, members
refused to coooerate with the AMEX staff during an inquiry. In none
of these situations was the member disciplined for his activities.

The Study has discussed these concerns with the AMEX. Subsequently,
senior officials at the exchange outlined a number of steps that might
be taken to imrrove AMEX investigation and enforcement programs.
Soecifically, they suggested that a special committee of the Board
of Governors should be established to review regularly all closed

262

case? and that more formal procedures for closing cases should be

devised. With resoect to the special committee, the Options Study

has been informed:

The Exchange Administration will recommend to its
Board of Governors that a soecial committee be
established to make oer iodic reviews of the
Rxchanne's compliance activities. This committee
would consist of the Chairman, the President, the
Executive Vice President for Legal and Regulatory
Affairs, one public governor and two industry
governors (one from the floor and one from
"upstairs") .

This committee would make an in-depth review at
least annually of the investigations and disciplinary
oroceedings conducted by the Compliance Eepartment.
The review would include types of possible improper
activities noted, including any patterns of activity;
standards and orocedures employed in making decisions
at each stage of a matter as to whether it should be
closed or a disciplinary proceeding brought; and
other matters relating to the work of the Compliance
Deoartment. 44/

In addition, the AMEX has undertaken to examine its case closing

orocedures with a view toward formalizing them.

Accordingly, the Ootions Study recommends:

THE AMEX SHOULD FORM A SPECIAL COMMITTEE OF
ITS BOARD OF GOVERNORS THAT WILL REVIEW THE
INVESTIGATION AND ENFORCEMENT ACTIVITIES OF
THE EXCHANGE. THE COMMITTEE SHOULD BE COMPOSED,

44/ Letter to Richard Teberg , Director, Special Study of the Options
Markets, from Norman Poser, Executive Vice President, American
Stock Exchanqe, dated October 3, 1970.

263

AS SUGGESTED, OF FLOOR AND NONFLOOR MEMBERS,
EXCHANCE OFFICIALS AND A REPRESENTATIVE OF THE
PUBLIC. IN ADDITION TO ITS GENERAL REVIEW,
THF COMMITTEE SHOULD SPECIFICALLY EXAMINE, AT
LFAST EVERY SIX "MONTHS, EVERY INVESTIGATIVE FILE
IN WHICH THE INVESTIGATIVE AND ENFORCEMENT
ACTIVITIES OF THE STAFF HAVE BEEN COMPLETED.
THE FILE SHOULD IDENTIFY THE REASONS THAT THE
INVESTIGATION WAS INITIATED, THE STEPS THAT
WERE TAKEN TO INVESTIGATE THE MATTER, THE
CONCLUSIONS THAT WERE REACHED CONCERNING
EACH ASPECT OF THE POTENTIALLY VIOLATIVE
CONDUCT, THE RATIONALE FOR EACH CONCLUSION,
AND FULL DOCUMENTATION TO SUPPORT THE RESULT.

FURTHER, COMMISSION INSPECTIONS OF THE AMEX
SHOULD EMPHASIZE A REVIEW OF CASE FILES THAT
ARE CLOSED AFTER INVESTIGATION TO ASSURE THAT
AMFX ENFORCEMENT RESPONSIBILITIES ARE PROPERLY
CARRIED OUT.

4. The MSF

The MSE keeos a loq of unusual option trading involving MSL options
and anv related stock activity. It also keeos a log of unusual activity
reports that its Order Book Officials file. The Options Study reviewed
these lens for approximately a two vear period and examined every investi-
gative file that the MSE had formally opened.

The review of surveillance logs and reports caused the Options
Studv to question the adequacy of MSE investigation and enforcement
efforts. The loqs contained numerous indications that questionable
tradinn practices may have occurred on the exchange, but MSE records
seldom contained evidence that the matter had been pursued in any

264

wav. As a consequence, it is impossible to determine the regularity,

adeouacv, or extent of exchange investigations of potential improprieties

that its surveillance systems detected. Moreover, the case files

that the Study did review suqgest that MSE investigations may not

be as thorouqh as its statutory responsibility mandates. Cases

were frequently closed before sufficient information had been obtained

to allow a proper determination of whether a violation had occurred,

and there was no indication that clearly improper conduct had been

investigated or sanctioned.

Accordingly, the Options Study recommends:

THE COMMISSION SHOULD CONDUCT A COMPLETE INVESTIGATION
OF THE MSE OPTIONS SURVEILLANCE PROGRAM. THE INSPECTION
SHOULD SEEK TO DETERMINE WHETHER THE MSE HAS THE ABILITY
TO ENFORCE COMPLIANCE WITH THE ACT, THE RULES AND
REGULATIONS THEREUNDER, AND MSE RULES WITH RESPECT TO
OPTIONS TRADING ON THE MSE FLOOR.

265

INHIBITS TO CHAPTER IV

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274

EXHIBIT 7

/©) American Stock Exchange Inc.

REGISTERED OPTION TRADER & SPECIALIST REPORT
OF ORDERS ENTERED IN OPTION RELATED UNDERLYING STOCKS

Datp For the account of

Clearing Agent

Note: To be filed with Trading Analysis Dept. by 11:00 a.m. on the first business day following the date the
order was entered.

(SIGNATURE)

ORDER DESCRIPTION

STOCK

TIME

ENTRY

TYPE OF ORDER

QUANTITY

EXECUTIONS)

POSITION

AT
OPENING

MARKET (Held, Not Held)
LIMIT (Specify price)

Day or
CTC

BUY

SELL

VOLUME

PRICE

275

EXHIBIT 8

MARKET MAKER

DAILY TRANSACTION REPORT

FORM -OTR 1

THE

PACIFIC
s™* EXCHANGE

INCORPORATED

CLEARING FIRM
TRADE DATE

CHECK ONE

B i

0 S

u o

G L
H D

T .

3 S

0 -

H i
T

-
0

p
u

Stock P

Svticci anai R Amount Time Time
or Odto-i 1 of Original Lm.i Oroer Oroer ?'ac; D'
Series C Owe- on Oroer Entered Executed E*ecu:<on

1 III

1 i

PREPARED BY

276

EXHIBIT 9

Mr. Richard Teberg, Director October 6, 1978

Special Study of the Options Markets
Securities and Exchange Commission
500 North Capitol Street
Washington, D.C. 205*5

Dear Mr. Teberg:

We are pleased to submit this letter in response to
the various issues raised by the Special Study of
the Options Markets (the Options Study) with respect
to the need for and creation of an integrated regulatory
system among the self-regulatory organizations (SRO's).
We will first make a preliminary statement concerning
the Option Study's objectives and discussions between
the self-regulatory organizations. We will then offer
substantive comments, preliminary conclusions and
recommendations under four headings: (I) Interchange
of Market Surveillance Information, (II) "Compliance
Plan" for Member Firm Examination and Information
Sharing, (III) Centralization of Compliance Data for
Registration and Investigation Purposes, and (IV) Allo-
cation of Responsibility.

Preliminary Statement

As you are aware, during August, 1978, the staff of the
Options Study held several meetings with representatives
of the following organizations: American Stock Ex-
change, Boston Stock Exchange, Chicago Board Options
Exchange, Midwest Stock Exchange, National Associa-
tion of Securities Dealers, New York Stock Exchange,
Options Clearing Corporation, Pacific Stock Exchange,
and Philadelphia Stock Exchange (hereinafter participant
SRO's or the group). Also participating were represen-
tatives of the Commission's Divisions of Enforcement,
Market Regulation and Consumer Affairs, and Mcnchi k-Weoer
Associates, Inc. These, d iscussions descr iced the Com-
mission's concerns which precipitated the request for
a Proposal For A Market Surveillance System as awarded
to Monchik-Weber Associates, Inc. as well as the pre-
liminary findings of the Options Study which indicate
the need for greater coordination of existing options
and securities regulatory systems so as to achieve
an integrated industry-wide regulatory system.

277
Mr. Richard Teberg Page Two

The meetings of the participants have focused upon the
need for the creation of an integrated regulatory system
among the SRO's which would enhance total industry regu-
latory capability by coordinating and interfacing exist-
ing regulatory data and programs through the sharina of
available information, improvement of regulatory tech-
niques, the allocation of regulatory responsibility and
the centralization of registration data and customer com-
plaints to facilitate access.

In particular, the Options Study has noted several areas
of concern which are indicative of its findings and which
should be addressed in order, in its opinion, to im-
prove overall regulatory capability of the SRO's. The
main objectives would be to eliminate overlapping ef-
forts which may presently exist, to fill existing voids
in regulatory programs and to promote the interchange
of and access to information. This is especially true
with respect to dual trading in options and stocks ar.d
intermarket options activities. These concerns center
upon whether there is a need for the SRO's to:

(1) share and improve existing data bases and in-
crease inter and intra-market cooperation;

(2) to enhance audit trails to promote intermarket
reconstruction and surveillance;

(3) enhance regulation of off-floor proprietary
and customer accounts;

(4) establish audit trails for position adjust-
ments, "as of transactions ar.d Clearing
Member Trade Assignment arrangements;

(5) establish minimum uniform standards which
trigger surveillance follow-up activity;

(6) establish uniform forms and letters request-
ing additional information from broker-
dealers with the elimination of duplicate
inquiries in the case of multiply traded
options and the underlying security;

(7) receive and process relevant information from
each SRO regarding registered personnel and
to utilize such in preparation for regulatory
examinations and investigations;

278
Mr. Richard Teberg Page Three

(8) conduct more examinations of member firms which
may incorporate regulatory methods and practices
which have not been routinely utilized by all
SRO's in the past;

(9) establish the method, form, and principles
upon which information available to one or
more SRO's will be accessed by other SRO's;
and

(10) establish uniform minimum compliance and dis-
ciplinary programs.

The Options Study also recognized the importance of
enhancing regulation of broker-dealers who, though
not a member of an options exchange engage in ex-
change listed options activity by going through a
clearing member (so called "access firm"). How-
ever, this prodem appears to be nearing resolution
by the Commission's recent conditional approval of
the NASD's "access" rule proposals. This situation
would be further improved if the SEC would now adopt
and approve comparable rules to regulate SECO and
other broker-dealers not covered by the rules governing
access firms or any other specialized options rules.

Although it is recognized by the participant SRC's

that complete integration of regulatory information

and systems may present technical and feasibility

questions, it is acknowledged that the establishment

of a more fully integrated regulatory system is

both necessary and desiraole as a means of establish ino

more efficient and effective regulation which may

be cost-effective to the industry and achieve minimum

standards of regulation on an industry-wide basis

thus assuring the protection of public investors.

Significant progress has been made by the particioants
toward the creation of an integrated regulatory system.
Numerous meetings and discussions have been held by the
group and sub-groups formed for the purpose of focusing
on specific issues including (a) interchange of ^arke:
surveillance information, (b) interchange of compliance
Information relating to firm examinations and sales
practices, (c) development of central files for regis-
tered personnel and customer complaints, (d) allocation
of regulatory responsibilities, and (e) leqal matters
to be addressed in order to achieve an integrated
regulatory system.

279

Mr. Richard Teberg Page Four

As a result of these discussions, the particioant
SRO's listed above met jointly for the purpose of
defining the ovrrall parameters of a comprehensive
regulatory system cased upon their complete and
thorough understanding of the capabilities presently
in place and, following such analysis, to make recom-
mendations for the implementation of the system.

The group, based upon the reports and recommendations
of its sub-groups, and its own deliberations to date,
has achieved agreement in several specific areas
and wishes to submit this preliminary report to acpris-
the Options Study of the material developments which
have occurred and to focus attention on those areas
which, although approved in principle by the various
SRO's, remain to be fully resolved before considera-
tion may be given to their later implementation. It
is clear, however, that continuing efforts will be
required in order to reach mutually satisfactory solu-
tions and that further meetings of the SRO's Wie-
the Commission's staff will also be required to
facilitate the implementation of desired programs.

I. Interchange of Market Surveillance Information

A sub-group was established on interchange of Market
Surveillance information. This body was directed
to identify all market surveillance reports and
information presently available to each participant
SRO in order to determine whicn information could
be integrated into other self-regulatory organizations'
programs to enhance existing regulatory efforts with
respect to intermarkei surveillance. This sub-croup
thereafter collected from and furnished to each par-
ticipant SRO, including the Options Clearing Corpor-
ation, copies of all option and equity computer
print-outs and certain manually prepared reports
(along with explanatory materials identifying the
type of data, format, frequency and purpose) which
are utilized in conducting market surveillance for
listed securities. In addition to disseminating
examples of data base information derived from
transaction and clearing streams, each organiza-
tion provided copies of reports which identify
activity which exceeds pre-determined parameters
during a trading session.

After the analysis of this voluminous information,
a better understanding of the nature of information
available was achieved. There was also a consensus
that the sharing of data by the various SRO's is
both needed and desired. However, while certain
agreements have been reached, it is yet to be deter-
mined whether all such information will be furnished
routinely or on some other basis. .

280

Mr. Richard Teberg Page Five

It is generally agreed that any information inter-
changed may be more desirable in a computer readable
format ratner than on microfiche or hard copy print-
outs for manageability and flexibility purposes.

Ful .her , it is noted that certain data which would
be useful to each organization is presently avail-
able on an on-line basis through sucn systems as the
OTIS system for collecting and displaying option in-
formation and for stock activity from the last sale
and quote information transmitted via high speed
lines. This information may be captured with ao-
propriate programming which is being explored.

During a general discussion of the adequacy of option
and stock data bases and audit trails, it became ap-
parent that a significant difficulty in an effective
and efficient integrated system is the reconstruction
of transaction data on the underlying security in a
form which identified the broker/dealers involved in
each transaction and whether they are actina as agent
or principal. Various participants expressed concern that
such a system mignt be very expensive to construct and
maintain and that these costs must be weighed.

After identifying the information available, the par-
ticipant SRO ' s expressed interest in the exchange of
market surveillance information as follows:

a) Reconciliation Clearing Sheets from markets where
securities underlying options are traded.

b) Daily Transaction Journal from all markets where
securities underlying options are traded.

c) Monthly Short Interest Reports by firm from all
markets where securities underlying options are
traded .

d) Block trade reports from all markets where securi-
ties and options are traded.

e) Notification of the initiation of investigations and
reviews, as appropriate.

f) Status reports on investigations and reviews, as ap-
propr iate.

g) Notification of trading halts.

281

Mr. Richard Teberg Page Six

h) Notification of corporate contacts resulting from
unusual trading activity.

i) Exercise/Assignment Listing Reports from OCC.

j) Open Interest Distribution Reports from OCC.

k) Market Data Retrieval Reports and Matched Trade
Listing Reports.

The equity exchanges indicated that they would be
responsive to inquiries by the options exchanges with
respect to matters which could affect trading in unde:
lying securities and options trading thereon and wouli
make every effort to inform other appropriate market
centers of trading halts.

With respect to the interchange of information per-
taining to multiply listed options, we believe that
useful data is currently being disseminated to the
options exchanges via the daily Options Clearing
Corporation compliance tape and that modifications
due to be implemented in the beainning of 1979 will
enhance monitoring capaoilities oy providing member
transactions in multiply traded classes executed on
other exchanges. These modifications, as currently
envisioned will consist of each participant SRO re-
ceiving the following:

a) All positions, exercises/assignments and ad-
justments of their memoers regardless of
where the options class is listed;

b) All cleared options transactions of their
market maker s/spec ial ists/reg istered traders;
and

c) All exercises, assignments, positions and adjust-
ments of non-members trading in classes which
are solely listed on their exchange.

There is general agreement among the participant SRC's
that they are willing to share information for surveil-
lance purposes subject to certain specific limitations,
i.e. non-member specialist and marketmaker positions
which would be provided on a case-by-case basis rather
than as a matter of routine. It is important to note
that the participant SRO's agree that all information
would be available to other SRO's for specific investi-
gations.

282

Mr. Richard Teberg Page Sever*

It was suggested that rather than receive information
from each option exchange the Options Clearing Corpor-
ation upon appropriate authorization could furnish a
modified daily compliance tape to non-OCC participant
SRO's which would contain the in'ormation requested
except for data pertaining to non-member specialists,
traders, and mar ketmakers.

The group recognizes that there could be problems in-
herent in providing an SRO information pertaining to
a non-member of that participant. It remains to be re-
solved whether such information is to be furnished on
a routine basis or only upon request.

With respect to the legal question of providing a par-
ticipant with information pertaining to a non-member,
the legal sub-group raised questions of legal liability.
It believes, however, the potential liability of SRO's
would be decreased if the action taken (a) is pursuant
to legitimate regulatory objectives under the Securities
Exchange Act of 1934 and does not involve excessive cr
gratuitous compromise of privacy or due process rights;
(b) has been duly authorized by the SRO's and approved
by the SEC; and (c) each SRO has implemented appropriate
rule changes to the extent necessary and/or has required
proper disclosure.

I I . Compliance Plan for Member Firm Examinations and
Information Snar mg

We established a sub-group to review current industry
compliance practices toward the goal of developing a
more standardized compliance program. This program would
utilize in part the concept of a central report mg of
relevant information concerning memoer firms. The aims
of such a program would be, among others, to promote
a sharing of relevant information aoout broker /dealer
compliance activities and to ass"ist in the execution
of complete, comprehensive and thoroucn examinations
of such firms. In addition, the group agrees with the
Options Study that it should be possiole to establish
some industry-wide ODjectives for the conduct of an
examination so as to insure the protection of investors,
avoid regulatory duplication, and eliminate regulatory
voids.

It is agreed that a broad "Compliance Plan" would include

I. Continual Monitoring Proqrams

II. Special Attention Programs

III. Examination Programs

IV. Disciplinary Programs

V. Educational Programs

283

Mr. Richard Teberg Page Eight

While we acknowledge that most, if not all, of the'
basic components of the programs noted above are
place and presently being utilized by one or more
of the SRO's, it is also agreed that certain of these
programs may have to be further refined so as to
increase their comprehensiveness and to facilitate
their use, as deemed appropriate, by each SRC.

We therefore agreed that the sub-group would reach an
understanding as to the components of each program
within the compliance plan and the objectives to
be achieved by each such component. In addition,
the sub-group would compile a list of the particular
data bases which could be utilized to accomplish
the objectives of each program component. The sub-
group is making progress in the above area and will
submit its future recommendations on these matters
to us for review and action.

In addition to the above, we have agreed that the com-
pliance plan sub-group should include within the scope
of its discussions matters such as:

the targeting of, and visits to, branch offices
for examinations;

• the enhancement of examination "audit
trails ;"

the uses of "intelligence" information re-
ceived frcm other SRO's; and,

a comprehensive pre-examination procedure.

III. Centralization of Compliance Data for Registra-
tion and Investigation Purposes

We established a sub-group to review the feasibility
and usefulness of creating a central repository for
compliance information. As a result of the sub-group's
recommendation we have determined that a repository
could be utilized to provide each self-regulatory
organization with more information than is presently
utilized for purposes of registration of personnel,
customer complaints, investigations and examinations.
We also believe that measures should be taken in
this area to decrease or eliminate duplication of
efforts among self-regulatory organizations and in-
crease the overall efficiency of such processes
within the industry. The group further aqrees that
the adoption of these measures should not, to the
extent feasible, result in increased costs to the
industry.

284

Mr. Richard Teberg Page Nine

The group discussed the concerns of the Options Study
regarding the concept of a registered representative
who transferred from firm to firm and through vari-
ous regulatory jurisdictions. It was agreed that a
central repository of registered personnel and cus-
tomer complaints may assist in following the movements
of such an individual and provide SRO's with more com-
prehensive data by which to judge his actions.

The NYSE offered to become the central repository for
general compliance information for those firms for
which it is the designated examining authority. The
NASD offered to include data elements relating to
customer complaint information on its automated system
for processing registered representative applications.
Such system presently contains certain data elements
of interest to the suo-group including termination
for cause information and final disciplinary actions
taken against registered personnel. Each SRC agreed
to furnish the NASD with output requirements they
would need from such central repository system with
the understanding that the NASD will outline for con-
sideration a system designed to meet tneir needs.

To date there has been no general agreement as to how
information could be used except to provide "intel-
ligence" for SRO's preparing for examinations ar.d
investigations. There was concern as to potential
legal obstacles which could prevent information
sharing, however, we have 'concluded that potential
legal liabilities would be reduced if the procedure
outlined on page 7 is pursued.

The group has agreed that, aside from the feasibility
of such a plan, a central file on registered personnel
which would include at least all information regard-
ing registration and termination, customer complaints,
and formal actions ta<en oy SRO's and other regulatory
bodies would be a worthwhile accomplishment. It is
generally agreed that such information would assist
each participant in determining whetner registration
was appropriate, whether closer than normal surveillanc
was warranted and would provide information useful in
the preparation and conduct of investigations and ex-
aminations .

Additional questions were raised concerning access
to such information and whether or not such a re-
pository would include matters which have not yet
reached a conclusive state at a regulatory body.
Representatives on the sub-group have agreed to review
the position of their organization with regard to the
sharing of this information keeping in mind the goal

285

Mr. Richard Teberg Pace Te

of accomplishing the total sharing of information
whenever possible. Additionally, the sub-group has
determined to address and resolve questions regarding
the methods of implementing such a proposal, access,
refinements in the use of information and the re-
sponsibilities of users.

IV. Allocation of Responsibility

We established an allocation of responsibility sub-
group to explore the means of identifying ar.d elimin-
ating duplicative regulatory efforts as well as the
measures necessary to improve regulatory programs.
The sub group was also requested to provide the -earns of
resolving such overlaps and shortfalls through the
allocation of responsibility for investigation and
enforcement and to assure, as much as possible, the
uniform interpretation and application of co~paracle
self-regulatory and Commission rules. The group focused
on problems involving jurisdictional issues where
membership in more than one self-regulatory organiz-
ation existed ar.d on inter-market trading activities
which transcended individual SRC jurisdictional
boundaries, soon as insider trading activities,
fraudulent and manipulative trading practices, tape
racing, front-running, expiration studies and other
specific inter-mar<et transactions.

Por purposes of its discussions, the participants
determined that non-member oro <er-dealers ar.d non-
member broker-dealer customers would oe treated as
the same type of entity for surveillance purposes.
It was also determined that where a ncn-memoer
(whether a broker-dealer or customer) effects a
transaction using the facilities of a member bro-
ker-dealer, the matter should be referred to one
SRO that has jurisdiction over that non-member
or to the SIC if a non broker-dealer customer is
involv ed .

Of course, questions of jurisdiction over a broker-
dealer which is a member of more than one self-regulatorv
organization and/or when a security is multiply traded
encompass much broader and complex issues arc conse-
quently consumed a significant portion of the aroup's
efforts. Based upon its discussions, the croup
agreed to consider the followinq principles of allo-
cat ion:

40-940 O - 79 - 21

286

Mr. Richard Teberg Page Eleven

(1) The surveillance and regulation of specialists,
market-makers and registered floor traders will
be retained by the self-regulatory organiza-
tions of which they are a member and on which
they fulfill such functions.

(2) The gathering of customer and firm information
needed in pursuing insider trading and manipulation
cases shall be allocated to the primary market in
that family of markets whenever there is a dually
traded security.

(3) Whenever an SRO conducting an investigation lacks
jurisdiction over a broker-dealer non-member,

the information necessary to conduct the inves-
tigation shall be obtained from any other self-
regulatory organization of-vnich such non-member
is a member .

(4) Expiration Studies - It was agreed that the SRO's
would inform each other when they are preparing
to conduct expiration studies of options vs.
stocks in order to prevent a duplication of ef-
fort. If two or more self-regulatory organizations
have decided to perform a similar study, they would
determine among themselves which would conduct the
study; however, where market-makers, specialists
and registered floor traders are involved, the
self-regulatory organizations of which they are

a member shall retain responsibility for inves-
tigating such matters.

(5) Disciplinary Procedures - Self-regulatory organi-
izations shall share information while retaining
jurisdiction of their own members; however,
where joint members are involved the market
where the violative activity occurred would be
responsible for disciplining the memoer unless
otherwise agreed upon.

(6) Employees of SRO's will be made available for
testimony as needed by other SRO's in any case
where their testimony is required or where
such employees performed a portion of an inves-
tigation or examination. (The self-regulatory
organizations will continue to review the oos-
sibility of requirina their members to testify

at disciplinary hearings of other self-regulatory
organizations which lack jurisdictional authority
over such members.)

287

Mr. Richard Teberg Page Twelve

In agreeing to these principles of allocation, we note
that certain initiatives in these areas have previously
been undertaken in the form of 17d-2 agreements which
have been entered into by t.ne various participants and
filed with the SEC. We urge the Commission to promptly
review and act upon those agreements which it has not
yet considered. ' In doing so, • -e recognize that they
are not all inclusive in respect to the matters which
are the subject of our discussions and that amendment
of the 17d-2 agreements may be appropriate as these
matters are implemented.

To accomplish our goals, it is anticipated that there
will be further discussion by the participants to
allocate additional responsibilities with respect to
matters arising from inter-market regulatory prcc-
lems and to further eliminate regulatory duplication.

The above presentation is a summary of principles
agreed upon oy staff representatives of the participan
SRO's and those questions remaining to be resolved
prior to achieving our objective of establishing
an efficient and effective integrated inter-mar icet
regulatory system. We are continuing to -meet in an
effort to achieve such a system. It must be borne
in mind, however, that certain aspects of these
programs would require formal action by the acvernir.g
bodies of the respective SRO's. Continued cooperation
on behalf of the SEC will, of course, be necessary
in order to achieve and implement these goals.

We welcome the Commission's participation at future
meetings.

Very truly yours

Amer ican Stock Exchange

Boston Exchange Exchange

288
Mr. Richard Teberg Page Thirteen

Chicago Board Options Exchange

Midwest Stock Exchange

National Association of Securities Dealers

New York Stock Exchange

Options Clearing Corporation

Pacific Coast Stock Exchange

Philadelphia Stock Exchange

CHAbTEK V
OPTIONS SELLING PKACTICLb

lNTrtJUUCTlON

Tne Options btudy exajuinea tne manner in wnicn brokerage firms
ana tneir registered representatives sell listed options to the pub-
lic in order to determine it signincant patterns of selling practice
auuses existed, borne or tne selling practices surveyed were sound,
wniie others appeared unetnicai and still otners were clearly unlawful,
inereiore, tne internal controls and procedures of brokerage firms were
analyzed lor tne specilic weaknesses wnicn had permitted these abuses
to occur. Mitnougn no attempt was made to quantitatively measure unsound
selling practices throughout the industry or tnrougnout a firm, it became
eviuent tnat, wnerever brokerage firms lacked adequate internal controls,
serious selling abuses were lixely to occur, most options selling abuses
are rooteu in tne failure of many brokerage firms to prohibit registered
representatives trom selliny listed options to the public before the
rirms tnejiiseives nave estaolisned necessary supervisory systems to control
tneir sales rorce. In many firms adequate internal controls are still lacking.
Tnis cnapter uiscusses tne selling practice abuses and internal control
oenciencies lounu by tne Options btudy.

Tne Uptions btudy naa access to ail the Coniuiss ion's investigative
rues relating to options selling practices and reviewed more than one
nunarea ana tirty options examinations of broker-dealer rirms conducted

(289)

290

bv the Commission's staff during the past 15 months. The Options
Study also reviewed the options complaint files of the Commission
and those of brokeraqe firms of all sizes and interviewed compliance
and sales personnel from brokeraqe firms. Finally, to gain a better
oerspective of their options business policies, and internal controls,
the Ootions Study sent a detailed Questionnaire to a sample of brokerage
firms sellinq listed options to the oublic. The sample consisted of
all brokeraqe firms carrying and clearing their own public customer
accounts which reported to the Commission listed options commission
revenues for 1977 of $500,000 or more (46 firms) and a random sample
drawn from 89 smaller brokerage firms whose listed options commission
revenues for the same period were between $100,000 and $500,000 (12
firms). The 58 firms which comprised the industry group sample
accounted for more than 70 percent of the total options commission
revenues earned in 1977 by brokeraqe firms which dealt with public
customers.

Brokerage firms are required by both the Exchange Act and the
rules of self-renulatory organizations to maintain adequate systems
of suoervision and control over the activities of all their employees.
A brokeraqe firm's suoervision of its employees must be adequate to
orotect its customers from illegal and unethical practices because,
as the Commission has explained:

291

Customers dealing with a securities firm
exnect, and are entitled to receive, oro-
oer treatment and to be protected against
fraud and other misconduct, and may properly
rely on the firm to provide this protection. 1/

A hiqh standard of supervision over registered reoresentatives

is reouired because of the Dotential for abuse of a customer's

trust. Cne court recently noted:

The registered representative and the broker-
dealer earn their money, directly and indirectly,
by sales activitv. Customers often rely on their
broker-representatives for investment advice.
"The ooDortunity and temptation to take advantage
of the client is ever oresent.' 2/

The complexity and leverage features of listed options trading
pose siqnificant risks for public investors and reouire unique super-
visory systems within broker-dealer firms. Adequate supervision of
listed options trading reouires brokerage firms to actively and con-
tinuously ensure that knowledqeable supervisory personnel oversee the
activities of registered reoresentatives, that registered representatives
are adequately trained and that they transact business only with those
customers who can aporeciate and bear the risks which options trading
entails. As oart of its suDervisory responsibilities, each brokerage
firm must oerform timely reviews of its account openings and of the

_V Peynolds & Co., 39 SEC 902, 917 (1960).

2/ Kravitz v Pressman, Frohlich & Frost, Inc., 447 F. Suoo. 203,
213 (D. Mass. 1978)

292

selling documents shown or sent to customers. In addition, each firm
must systematically oversee the trading activity in customer accounts
and toliow sound recordkeeping and back-olfice procedures.

In uiany cases examined by the Options Study, customers have
suirered unnecessary losses that might have been prevented by adequate
supervisory controls, for example, because brokerage commissions alone
provide a strong incentive tor registered representatives to recommend
listed options, tne Options Study tound tnat customers had been switched
irom conservative long-term investment positions into active short-term
trading in listed options witn little or no regard to the suitability
or tnis new type of trading tor the customer. Other customers were
initially attracted to options trading by misleading advertising and
otner promotional materials produced by the firm or its registered
representatives. Altnough some of these customers did not understand
options, or nave tne financial ability to bear the risks of options
trading, tney were permitted to open options accounts and trade options.
Too trequently, registered representatives, lacking proper training
and supervision, involved customers in elaborate options transactions
or programs so complex that neitner they nor their customers fully
understood tnem. as a result, these transactions were occasionally
constructed in such a way that, unknown to tne customer, the best
outcome ne could possibly achieve would be to break even. In other
transactions, tne customer's maximum potential profit was much less
tnan tne commissions ne was charged.

293

Customers generally are not provided adequate, usable information
to enable them to appreciate fully the risks or results of trading listed
options. Monthly account statements, which are supposed to inform the
customer of the status of his account, generally do not give the customer
sufficiently detailed information to monitor his trading activity. Options
customers, on the other hand, often do receive from brokerage firms
detailed selling documents, such as worksheets and performance reports.
These documents may be misleading because they sometimes provide little
or no exDlanation of the risks of the options transactions being recommended,
or because they contain unrealistic projections of high rates of return.

Most brokerage firms rely on a system of branch office managers,
comolemented bv a home office compliance unit, to oversee the trading
in customer accounts. Many local supervisors, however, are not properly
oreDared to understand options or to control listed options trading
in customer accounts. Similarly, home office compliance systems often
do not provide adeouate review of customer options trading, especially
trading in discretionary accounts opened as part of some options investment
programs. These problems of supervision are further compounded by
inadequacies in certain back-office and recordkeeping practices which
decrease the efficiency of both the firms and regulators in determining
compliance with rules.

294

un tne oasis of its review, tne Options Study is recommending
changes in tne rules ot self -regulatory organizations for the
purpose ot improving and strengthening internal control systems
in oroKerage tirms. Tne Options Study recommends that these
minimum requirements be imposed on all brokerage firms selling
listed options to tne public regardless of the self-regulatory
alt illation ot the lirm.

Tne examples used in the chapter to illustrate abuses and
regulatory problems are drawn from the Commission's files. All
customer accounts described were selected from among actual cus-
tonter accounts analyzed by tne Commission's staff although sane
numbers nave oeen rounded and, in one case, part of an account
was deleted to simplify analysis without compromising conclusions.
Names ana dates nave been changed wherever appropriate. Excerpts
iroiii registered representative - customer conversations or from
sworn testmony are taken from tapes and transcripts reviewed
oy tne Options Study.

Certain selling practice issues which the Options Study has

not addressed, but which deserve future scrutiny by tne Commission and

its statf, are:

. Exercise practices, at botn OCC and broker-dealer
iirms including tne fairness of certain practices
sucn as automatic exercise and exercise of abandoned
customer options and tne risks tnese and other
exercise practices entail for public investors;

295

The role of the investment adviser as an options
consultant and the relationship of options advisors
and their services to brokerage firms;

The relationship between options selling practices
and the growth in the number and size of margin
accounts;

The relationship among firm proprietary trading,
firm research recommendations on underlying stock,
customer options trades and the recommendations
made to customers;

The effect of listed options trading on the customer
account transfer practices. of brokerage firms.

The need for an options regulatory program for
SECO broker-dealers.

296

A. REGISTERED REPRESENTATIVE QUALIFICATION, PREPARATION AND MOTIVATION
1. Introduction

The soundness of oDtions selling practices rests ultimately on
the training and attitude of the persons who sell options to the public.
While many of the sellinq practice problems found by the Options Study
miqht have been avoided if brokerage firms had better supervisory or
surveillance programs, the first means of avoiding such problems is
to establish controls and to develop incentives which encourage integrity
and promote hiah standards of performance on the part of registered
representatives who deal directly with public investors.

A number of controls and incentives are essential if high stand-
ards are to be established and maintained:

(1) First, the industry-wide requirements for allowing
individuals to become "qualified" as options salespersons should
be stringent enough, and the on-the-job and classroom training
provided to registered representatives within each firm should

be riqorous enough, to assure that only persons reasonably proficient
in options are permitted to sell options to the public.

(2) Second, a system of incentives must be developed within
each firm to encourage registered representatives to give adequate
consideration to their customers' best interests when recommending
or effecting options transactions for customer accounts.

297

(3) Third, the hiring and termination practices in the industry
must be directed toward assurinq that oersons seeking employment
as registered representatives are properly screened, and that registered
representatives who have demonstrated an inability or unwillingness
to deal fairly and honestly with their customers are removed from
the business.

In all three areas, the Ootions Study has found that controls
are inadeouate to assure that only knowledgeable and properly
motivated registered representatives sell listed options to the public.

2. The Qualifications of Persons Who Sell Options

Several of the options-related customer problems reviewed by the
Options Studv were caused by registered representatives who did not
understand listed options. These problems might have been avoided
if the registered representative involved had been required to
undergo a meaningful Qualifying and training process before he was
oermitted to sell options to customers. The present requirements
are inadeouate in this regard, and, as a result, many registered
representatives now servicing the accounts of options customers
lack the necessarv knowledge and skill to perform their functions
Drofessionally.

298

a. The options qualifying examination
The options exchanges all require that employees of member firms
be registered with the exchange before they are permitted to sell that
exchanqe's listed options to customers. As a prerequisite to registra-
tion, the salesperson must pass an options qualifying examination.

Two examinations are presently in use. The NASD "Series 7"
Qualifying examination is given to all applicants who are new to the
securities industry and who are seeking to become registered to sell
securities for the first time (i.e. , to become "registered represen-
tatives"). The "Puts and Calls" examination is given to persons who
are already registered representatives, but who passed the Series 7
examination (or became registered on the basis of earlier standards)
before listed options were included in the registration requirements. 3/

The Series 7 examination consists of 250 multiple choice
questions and covers virtually all types of securities products
available to investors. Questions relating to listed call options
have been included in the examination since May 1977. At present,
approximately twenty questions — eight percent of the examination
— directlv concern options, and, on occasion, as many as ten more

3/ For a short period of time the Series 7 examination included
questions on calls but not puts, and persons who took the test
during that period subsequently had to pass a separate "Puts"
examination if they wished to offer puts to customers.

299

•questions may ue devoted to tne margin treatment of options trans-
actions. An applicant must achieve a seventy percent correct score
to pass tne examination (175 correct answers); none of the subjects
is scored separately. The examination is "closed book" and is
administered once a month at various NASD testing centers around
tne country.

as presently structured, the Series 7 examination has little
relationship to tne actual qualifications of a person to sell listed
options. Since only twenty questions directly concern options and
since an applicant may miss a full seventy-five questions without
tailing the examination, an applicant may miss every options question
and still Decome "qualified" to sell options.

un tne otner nand, the "Puts and Calls" examination, which consists
of rorty to titty multiple choice questions, is devoted entirely to
options. To pass this test, a person would appear to need some
understanding of tne product. As with the Series 7 examination,
nowever, the industry nas permitted those who take the "Puts and Calls"
test to pass it witnout necessarily possessing any knowledge of options,
t'lrst, tne examination is given "in house" which means that brokerage
tirms may devise their own procedures for administering the test. The
opportunity for abuse is apparent, and it is not surprising that rumors
aoound as to widespread misconduct in the administering of the test.

300

second, no otficial passing grade has ever been established for the
examination (altnougn a "rule-ot-thumb" seventy-five percent passing
score nas been suggested by tne CBOE). The established brokerage firm
procedure following the examination is tor the options supervisor
wno administered tne test to "review" with each candidate his incorrect
answers and then to retest him until ne "passes." For this reason, the
"Puts and Calls" test, like tne Series 7 examination, does not serve to
assure tnat options "qualified" registered representatives are know-
ledgeable about options.

In view of the present unsatisfactory status of the qualifying
examinations given to persons seeking certification to sell options
to tne public, the Options Study recommends:

THE SELF-REGULATOKY ORGANIZATIONS SHOULD AMEND
THEIR RULES TO REQUIRE THAT THE REGISTERED
REPRESENTATIVE "OPTIONS QUALIFYING" EXAMINATIONS
BE REVISED TO REQUIRE A THOROUGH KNOWLEDGE OF
UPl'IONS AND OF APPLIABLE OP1IONS RULES DESIGNED
TO PROl'ECT CUSTOMERS. THESE EXAMINATIONS SHOULD
b£ REaU'iINISTERED TO ALL OP1IONS SALESPERSONS,
AND ALL EXAMINATIONS SHOULD BE GIVEN UNDER CONTROLLED
SURROUNDINGS Bf INDEPENDENT EXAMINERS.

o. The training requirement

Tne rules of tne AMEX and CBOE provide that, in order to be

registered, a prospective options salesperson must not only pass

an options examination, but must also "successfully complete a

training course" (CBOE) or "nave a minimum period of four months

301

traininq and experience" (AMEX). _4/ The training component of
the registration reouirement is not strictly enforced, however, •
so that firms are free to decide for themselves how much, and
in what manner, options traininq should be given to prospective
salespersons. As a result, the amount of time and effort devoted
to classroom and on-the-iob training varies widely from firm to
f ir™.

Reqistered representatives who wish to offer options to customers
should be given practical, supervised, on-the-job training which the
oresent svstem does not assure.

Accordingly, the Options Study recommends:

THE SELF-REGULATORY ORGANIZATIONS SHOULD ADOPT
RULES TO REQUIRE THAT THE TRAINING OF REGISTERED
REPRESENTATIVES WHO RECOMMEND OPTIONS TRANSACTIONS
TO CUSTOMERS BE FORMALIZED TO INCLUDE A MINIMUM
NUMBER OF HOURS OF APPROVED CLASSROOM AND ON-THE-
JOB INSTRUCTION.

3. Motivation

Adeauately trained and tested registered representatives must

also be oroperlv motivated if they are to serve customers fairly. 5/

_4/ Rule 9.3, CBOE Guide (CCH) f 2203;
Rule 341, 2 ASE Guide (CCH) 1| 9391.

5 / The dutv of a registered representative to inquire about a

customer's investment objectives, financial situation and needs
and, based on that information, to determine whether or not
options transactions are suitable for the customer , is dis-
cussed in subchapter C, "Suitability", infra.

40-940 O - 79 - 22

302

But, reqistered representatives are subject to a serious conflict
of interest that arises from the dual role they must play when servic-
inq customer accounts. On one hand, the registered representative is
an advisor to his customers and an agent who ought to act with his
customers' best interests in mind. At the same time, in most firms the
reaistered representative is a salesperson whose only, or principal,
comoensation comes from commissions which are related to the size and
freouencv of transactions in his customers' accounts. This compensation
system creates a temptation for the reqistered representative to effect
trades in his customers' accounts - trades which may or may not be in
the interests of his customers - in order to derive income.

Coupled with the short-term nature of options, the industry's
commission rate structure makes options a particularly attractive sales
item to a reqistered representative whose livelihood depends upon
commissions. The commission structure of the securities industry has
traditionally called for hiqher charqes for transactions in low-priced
securities. This structure has been retained in the commission
rates most firms charqe their options customers. For example, a
customer qenerally will pay a larqer commission on an options trade
consistinq of 10 calls at $5 ($500 per contract) than on a stock
trade consistinq of 100 shares at $50, even thouqh the value of the
securities in both transactions is $5,000.

303

To aive a soecific example, consider an investor who buys 5
call contracts, or iced at $200 a contract, for a total purchase
or ice of $1,000, olus commission. Most firms do not calculate
this commission as thouqh 5 units were purchased at $200 each.
Instead, each call ootion contract is equated to 100 shares
of stock, and the option on each share is assigned a unit value
of $2. The commission is based on a purchase of 5 contracts of
100 units each, or 500 units at $2 for each unit. Using rates
tyoical in the industry, the investor is charged $57.20 for 500
units at $2 instead of $25.00 for 5 units at $200.

The Ootions Study requested from each firm in the industry group
samole a current commission rate schedule. Table I below summarizes
certain of the information provided. This table displays commissions
as a oercentaqe of the cost of buying 100 shares, 500 shares and 1000
shares of stock at $50 oer share, and 1, 5 and 10 options contracts
eouivalent to 100, 500 and 1000 units at prices of $.87, $5 and $10
oer unit.

304

The
Trade

Dollar
Value
of Trade

TABLE I

Industry
Sample Range

Average
Commissions As
industry Percentage of

Sample Average Dollar Invested

low

high

1 call (a $ .87

$ 87.50

$ 6.25

- 30.00

$ 13.77

15.74%

5 calls (a .87

437.50

20.00

- 53.75

40.44

9.24%

10 calls O .87

875.00

35.00

- 101.60

78.34

8.95%

1 call <a $5

500.00

18.04

- 29.40

23.30

4.66%

5 calls @ $5

2500.00

74.50

- 106.70

86.83

3.47%

10 calls <a $5

5000.00

127.00

- 181.05

149.16

2.98%

1 call 0 $10

1000.00

25.00

- 37.50

29.08

2.91%

5 calls (? $10

5000.00

97.00

- 132.89

114.08

2.28%

10 calls @ $10

10000.00

172.00

- 247.68

211.26

2.11%

100 shares <a $50

5000.00

71.50

- 96.12

82.18

1.64%

500 shares @ $50

25000.00

325.00

- 390.48

343.64

1.37%

1000 shares (a $50

50000.00

499.28

- 599.14

524.97

1.05%

As Table I portrays, the commission rate applied to low-priced
securities is substantially higher than that applied to higher
oriced securities. Three trades involving an investment of $5,000
are included: 100 shares at $50, 5 call contracts at $10, and 10
call contracts at $5. The commission charges (industry average)
for these trades are as follows:

100 shares @ $50

$82.18

5 calls @ $10

$114.08

10 calls @ $5

$149.16

The higher commission structure on listed options, however, is only one
of the incentives to a registered representative to recommend listed
oDtions to his customers.

305

This incentive is qreatly magnified by the opportunity for repeated
trades of ootions which is a result of their limited life span. For
examole, assume a customer desirinq to buy 500 shares of Upjohn
at $50 oer share could be convinced by his registered representative
also to start a covered options writing program by writing five
Uoiohn calls three months from expiration, and to repeat the process
at each exoiration date. The registered representative could real-
istically anticipate eight to twelve additional commission charges
durina the next year, iust from the options. Thus, based on the
industry arouo samole commission average, the registered representative
could expect to receive a stock commission of $343 as well as
$500 to $1,000 in options commissions from the above transactions.
Of course, if any of the calls were exercised, additional stock
commissions would be earned on the exercise and the repurchase
of Uojohn stock reauired to continue the covered options writing
oronram. Still further options charges would also accrue if, as
a result of a siqnificant move in the price of the stock, an existing
options position level was closed out and a new options position
established.

A sales guide of a national brokerage firm, which was distri-
buted to its registered representatives, pointed out the commission-
related incentives to salespersons for engaging their customers in
options trading. The guide stated:

306

[Ootions Writinq] can be the best revenue producer available to
fa registered representative] .

1. An account will generate 5-10% in conmissions
based on the money in the program i.e. if [the
customerl invests $25,000, [you] will receive
$1,250 to $2,500 a year in commissions.

2. If fyou] open one $25,000 account a week, you
will earn at the rate of $62,500 to $125,000
oer year .

3. If [youl margined all of them - you would be
earninq in the $125,000 to $250,000 category
- with only 50 accounts.

The same document included the statement:

Ootions are like an annuity. Once in operation,
they must do business several times each year. As
options come due, action must be taken... Many
reqistered representatives move money six to seven
times a year. Easy to see how [you] can generate
10% in commissions. (Emphasis added.)

The effects of the commission rate structure on the selling
of listed ootions underscore the need for adequate preparation
of options salespersons and for strong supervisory controls over
their sellinq activities.

4. Hiring and Termination Procedures

While the overall quality of the options sales force would be
enhanced, and its performance improved, if the testing, training
and suoervision of registered options salespersons were upgraded,
still another regulatory control must exist if the public is to

3o;

ue protectee trom tne unsatistactory performance ot salespersons.
DroKeraye nrms must desiyn — and implement — hinny ana employment
termination procedures capaoie ot identiiyiny and removing individuals
wnose on-tne-jOD pertonnance nas proved harmful to customers,
a. Hiring procedures

lb assure 'that persons applying tor positions as securities
salespersons have tne requisite character and capaoilities to service
customer neeas adequately, the NYbE requires that member firms "make
a tnorouyn inquiry into tne previous record and reputation of persons
wnom they contemplate employ my." Tne NYSE recommends tnat "[t]he
DacKyrouixi aixi reputation check should, whenever possiole, include
at least personal conversations with all employers dunny the previous
3 years ..." 6/ Tiie options exchanges liKewise require that their
members maxe a reasonaole investiyation ot the credentials of all
prospective employees. 7/

Virtually ail the firms in tne industry group sample, when queried
oy tne Options btuoy aoout their niring practices, responded that
tneir procedures included sane background review of every job applicant,
mciudiny a cnecK ot tne applicant's most recent employer and other
employers. However, the responses of most firms in the sample

_b/ Kuie 345, 2 NYbL Guide (CCH) 1i 2345.18.

7/ bee, e.y., Rule 340. U2, 2 AbE Guide (CCri) M 9390,

308

indicated that these firms did little more than comply with the
minimum requlatorv reauirements. And, while existing or former
customers are generally an excellent source of information concerning
a reqistered representative's performance, very few firms indicated
that thev contacted such customers as part of their background
check orocedures.

Even the limited checks required by the existing self -regulatory
rules, if followed, might be adequate to screen individuals seeking
nositions as reqistered representatives. In practice, however, partic-
ularlv with resoect to reqistered representatives already employed in
the industry, individuals who have patently unsatisfactory performance
records seem to be able to find employment at new firms if they have
records of venerating large commissions.

The breakdown in hiring controls appears to result from two
oervasive i.ndustrv practices. First, when asked by the hiring firm to
evaluate a reqistered representative's performance, the registered
representative's existing or previous employer does not always give
a candid assessment. The lack of candor may be explained in several
ways. Che reason suagested to the Options Study is that firms are
fearful of being subject to defamation lawsuits brought by registered
representatives who believe their careers have been damaged or

309

retarded bv their employers' unfair or untrue assessments of their
performance. Other reasons for lack of candor may be the desire of
a firm to rid itself quietly of an unsatisfactory salesperson, or the
concern bv the firm that lawsuits brouqht by unhappy customers of the
deoartinq registered representative miqht be aided by evidence that
the firm was aware of the registered representative's shortcomings.

The concern about defamation lawsuits is legitimate only insofar
as a firm's negative impressions of an employee cannot be substantiated
bv objective evidence. Thus, such evidence as written or oral customer
complaints and repeated (and recorded) violations of a firm's procedures
should, in most circumstances, enable a firm to avoid, or to counter
successfully, a charge of defamation. Only with regard to those employees
who violate no rules, or create no significant problems for customers,
but who simDly make an unfavorable "subjective" impression, is a firm
justified in withholding a negative report. The desire to be rid
of a or obi em salesperson, or the desire to avoid recompensing injured
customers — are not legitimate reasons to avoid candor in a self-
renulatory svstem designed to foster integrity of the marketplace and
to orotect public customers.

A second cause for the breakdown of hiring controls is that
the hirinq firm does not always heed warnings from the former employer
about a registered representative's unsatisfactory performance record.

310

The Options Study has reviewed several cases in which the quest

for the "biq oroducer" has caused a firm deliberately to dis-

reqard warnings. In one such case the firm knowingly hired two

salesmen who were under suspension by their former firm because

of serious unresolved customer problems. The salesmen were hired

over the objections of the firm's compliance officer who later

comolained that the salesmen had been "shoved down [his] throat."

In another case a registered representative, who had already been

suspended once by the Commission, passed throuqh two firms and

was hired by a third in a short period. His job application was

beinq considered not because he was a "big producer", but because

his brother was a "big producer," and the two together formed part

of the sales "package". In each firm the salesperson created

customer problems which the next employer firm knew about, or

would have known about if it had been warned by or had diliqently

asked the prior employers.

Two cases particularly illustrate how lack of candor by former

employers, and indifference to obvious problems by prospective employers,

have allowed options salespersons with unsatisfactory records to stay

in business:

Mr . B, a reputed "options expert," was employed at ten
brokeraqe firms from 1969 to 1978. Mr. B's employment was
terminated by major brokeraqe firms in 1975, 1976 and 1977.
In each case Mr. B left behind customers complaining of his
mistreatment of their options accounts. A self -regulatory

311

organization had taken disciplinary action against Mr. B in
both 1977 and 1978 on the basis of customer complaints.
Mr. B and each of the firms he was associated with in 1975,
1976 and 1977 have been sued by customers alleging fraud
and churning by Mr. B. A termination notice filed with
a self-regulatory organization by one of these firms was
false as was one application for employment completed by
Mr. B and filed with several self-regulatory organizations.
Mr. B is today the national sales manager of a registered
brokerage firm.

Mr. A's employment was terminated by a major brokerage
firm in 1975. The firm filed a termination notice which
stated that Mr. A had been the subject of several serious
customer complaints and that the brokerage firm believed
that Mr. A should not be rehired in the securities industry
because he had admitted doing unauthorized options trades
in customer accounts. Nonetheless, Mr. A was hired by
another major brokerage firm within two days even though
it was aware of the termination notice. Sixteen months
later, Mr. A left to join still a third firm as an options
salesman. At the third firm Mr. A filed an application
for employment which was false in that it denied any
former serious customer complaints or related conduct.
Within six months Mr. A was fired from the third brokerage
firm again for doing unauthorized options trades in
customer accounts.

b. Termination procedures

As discussed in Chapter VI, the NYSE, NASD and the options

exchanges all require member firms to file notices with them when

a salesperson leaves the firm for any reason. Notification forms

are provided which specify the reasons for termination. The reasons

generally fall into the following categories: (1) voluntary resignation;

(2) permitted to resign; (3) discharged; (4) deceased. The rules

require that member firms file the termination forms promptly

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following termination, and, among other things, that the firms
disclose whether the terminated salesperson had been the subject
of any major customer complaints.

The notification requirements enable the self-regulatory organi-
zations to learn of possible misconduct which might reflect on the
qualifications of a registered representative to serve public customers.
For the notification requirements to serve useful purposes, the cir-
cumstances of employee termination must be stated accurately and
truthfully. The Options Study has seen indications, however, that
firms are not always truthful in their disclosures. For example:

A major broker-dealer firm fired a registered
representative and quietly settled the claims of
six complaining customers (paying more than $60,000
in claims, some options-related), before notifying
the various self-regulatory organizations of the
termination of the salesman involved. In the
notification forms, the firm answered "no" to
the question whether the salesman ever had been
the subject of any major complaint by a customer
of the firm.

After receiving written complaints about a sales-
man from at least three customers, and being aware that
others would be forthcoming, a firm discharged the
salesman. The firm answered "no" to the question on
the termination form which asked about customer
complaints.

Misrepresentations made by firms to each other or to self-
regulatory organizations seriously undermine an important premise
on which securities industry self-regulation is based — that brokerage

313

firms will deal honestly with each other and with the self-regulatory
organizations of which they are members, to assure that high standards
of conduct prevail in the industry. When such misrepresentations involve
employee misconduct, however, they seriously hinder self -regulatory
efforts to shield public customers from unsatisfactory registered
representatives. '

The Options Study believes that the recommendations in Chapter VI,
concerning the establishment of a central file containing, among other
information, all customer complaints received on particular registered
representatives, will greatly reduce the problems presently caused
by inaccurate and false termination notices. Nonetheless, the
self-regulatory organizations must protect the integrity of their
filing systems by bringing prompt disciplinary action against
those member firms and their employees who file false termination
or registration notices with them.

314

B. SUPERVISION OF ACCOUNTS

1 . Introduction

The intricacies associated with trading options are such that
strict supervision of each registered representative's activities
by his brokerage firm is essential to the protection of public
customers.

The self-regulatory organizations impose a duty on brokerage
firms to supervise the professional conduct of their employees, and
the Exchange Act provides for the imposition of sanctions upon any
broker aqe firm (or responsible employee) which fails in its supervisory
obliqations. _8/

The NASD's rule is the most explicit of the self -regulatory
organizations' rules in spelling out the obligations of its member
firms to supervise. In essence, member firms must have and use
written supervisory procedures, which a designated partner, officer
or office manager is responsible for carrying out in each "office
of supervisory jurisdiction." 9/ Further, in order to supervise
emplovees adeauatelv, member firms must: keep necessary records;

_8/ Section 15(b)(4)(E), Securities Exchange Act of 1934, 15 U.S.C.
78p(b) (1978).

_9/ An "office of supervisory jurisdiction" means any office, including
branch offices, desiqnated as directly responsible for the review
of the activities of registered representatives. NASD Rules of
Fair Practice, Art. Ill, § 27 ( f ) , NASD MANUAL (CCH) 11 2177.

315

review the activities of each of their offices, "including a periodic
examination of customer accounts, to detect and prevent irregularities
and abuses"; conduct an inspection, at least annually, of each office
which has supervisory jurisdiction; and review and initial all relevant
transactions and corresoondence of the firms1 registered representatives
who solicit or execute securities transactions. 10/

That these requirements apply to an "office of supervisory
iurisdiction" reflects the generally decentralized management
structure of manv brokerage firms that do business with the retail
oublic. Brokerage firms usually maintain a central or headquarters
office and various regional and branch offices, each under the super-
vision of a desiqnated manager. Tne Cptions Study has found that
customer-related problems often proliferate when a firm's supervisory
rxocedures do not adhere to the above rules and are not carried out
consistently frcm one office to the next. The problems are exacerbated
for options customers because current regulatory requirements do not assure
that supervisors knowledgeable in options will oversee the options business
of the firm, either in the central office or the branch offices.

10/ NASD Rules of Fair Practice, Art. Ill, § 27, NASD MANUAL (CCH) u 2177.

316

2. The RQP System

When the CBOE introduced trading in listed options, it recognized
that firms offering this new and complex product to the public ought
to have one person within the firm's management structure who possessed
some expertise about listed options. Accordingly, the CBOE required each
member firm to designate one officer or general partner to be the
firm's "Registered Options Principal" ("ROP") who would be responsible
for "the supervision... of all [the firm's retail] customer accounts"
insofar as those accounts traded options. 11/ The ROP would be required
to pass a qualifying examination in options.

The CBOE, however, did not fashion its rule to fit the decentralized
management structure of broker-dealer firms. Instead of requiring
that the options business of each sales office of a firm be supervised
by an ROP, it provided only for the designation of one home office
ROP. As other exchanges began to offer options, they, too, adopted
the ROP concept and required that their members designate an officer
or partner to be the firm's ROP. 12/ Like the CBOE, the other exchanges

11/ Rule 9.8, CBOE GUIDE (CCH) 11 2309. Later, when the number of
Registered Options Principals in each firm multiplied causing
some confusion as to precisely where responsibility for compliance
with exchange rules lay, CBOE revised its rules to reestablish
the concept of a single senior managerial officer with supervisory
responsibilities for the firm's overall options business. This
new "chief" options supervisor was dubbed "Senior Registered Options
Principal" ("SROP").

12/ See, e^. , Rule 920, 2 ASE GUIDE (CCH) 11 9720.

317

reouired that members designate only one options-qualified person
to supervise the firm's entire listed options business.

The ROP concept is the primary supervisory innovation developed
bv options exchanges to deal with increased problems of supervision of
options accounts. The ROP concept may eventually prove to be a sound
orinciole on which firms may build acceptable options supervisory
systems. The Options Study has found, however/ that as presently
desiqned and imnlemented , the ROP system is inadeauate to assure proper
suoervision of a broker-dealer firm's business in listed options. The
shortcomings of the present system are discussed below.
3. ROP Qualifications

The first problem with the ROP system of supervision is that con-
trols for Qualifying persons as ROPs historically have been inadequate.
In addition, the ROP examination itself has been deficient in certain
respects.

The current CBOE rules provide that "[p]ersons engaged in the
manaqe^ent of [a member firm's] business pertaining to Option Contracts'
may aualify to be desionated a registered options principal by passing
a written examination. 13/ The AMEX rule is virtually identical. 14/

13/ Rule 9.2, CBOE GUIDE (CCH) % 2302.
14/ Rule 920, 2 ASE GUIEE (CCH) 1| 9720.

40-940 O - 79 - 23

318

Persons who take the ROP examination may ask to be qualified by both
the CBOE and the AMEX or by either .

The examination is administered by the NASD under contract with
the options exchanges and it is given at local NASD test sites. The
maior weakness of the current examination is that the same version of
the test has been used numerous times so that specific test questions
may be known to many applicants before they take the examination. In
addition, the examination itself places too great an emphasis on the
mechanics of options trading and not enough on the supervision of
listed options tradinq. Approximately 90 percent of the current
candidates successfully pass the ROP examination.

While the current examination, although not perfect, serves as
a useful screening device for persons seeking certification as ROPs,
the ROP Qualification process did not always include a meaningful
examination requirement. Before 1975, candidates could qualify
for ROP certification simply by taking an open book examination
administered at their own brokerage firms. In 1975, when the AMEX
opened its facilities to options trading, and formalized ROP examination
procedures were introduced, those persons who already had taken the
ooen book test were exempted by the CBOE from the new examination
requirements. As a result, more than five hundred existing ROPs have
never been tested under controlled conditions. The failure of the
CBOE to reouire that all member firm ROPs pass stringent, properly

319

administered examinations has allowed persons with questionable
qualifications to become certified as ROPs. Not surprisingly, the '
Options Study has found cases where ROPs in critical compliance
positions in brokerage firms have exhibited only a limited knowledge
of options trading.

The growth of a strong ROP system would be beneficial for the
protection of public investors, since bona fide ROPs should have
enough expertise in options to enable them to supervise their firm's
options business. The value of the ROP system is substantially
reduced, however, if all ROPs are not required to successfully
complete an examination given under controlled conditions at neutral
testing sites. And, of course, for the examination to serve as a
true qualification test of options expertise, it should require
candidates to demonstrate substantial detailed knowledge of options
and an understanding of rules and regulations concerning options
trading. Accordingly, the Options Study recommends:

(1) THE REGISTERED OPTIONS PRINCIPAL QUALIFICATION
EXAMINATION SHOULD BE REVISED SUBSTANTIALLY TO
TEST ROP CANDIDATES' UNDERSTANDING OF SUPER-
VISORY REQUIREMENTS RELATING TO OPTIONS

AS WELL AS THEIR KNOWLEDGE OF OPTIONS:

(2) ALL REGISTERED OPTIONS PRINCIPALS SHOULD BE
REQUIRED TO SUCCESSFULLY COMPLETE THIS REVISED
VERSION OF THE EXAMINATION ADMINISTERED UNDER
CONTROLLED CONDITIONS.

4. Problems of Local Supervision

As noted above, the managerial structure of the brokerage industry
is largely decentralized. Most firms rely heavily on branch office
managers to supervise the conduct of registered representatives. The

320

arrival of listed options trading placed significant new responsibilities
on branch manaqers, many of whom were unfamiliar with options and
with the rules and regulations of the new options exchanges. Their
lack of preparation notwithstanding, these managers were required
to administer a new body of account approval, suitability and reporting
rules; they also were expected to understand the mechanics of listed
ootions trading and the various options strategies used by the registered
reDresentatives and customers in their branch offices.

Many branch managers have been unable to cope successfully with the
suoervisorv challenges posed by listed options trading. The Options
Study believes that several factors have contributed to their lack
of success as options supervisors. These factors include:

- the traininq requirements for branch managers, who need not be
qualified as ROPs under present options exchange rules;

- the orevailing methods of compensating branch managers, which
favor commission revenue production over careful supervision;

- overall lack of support for local supervisors from the firm's
central management.

a. Unqualified branch manaqers

As stated earlier, when trading began in listed options, the CBOE

required member firms to desiqnate one senior employee to become the

firm's oDtions suoervisor (the ROP) but stopped short of requiring

that each branch office of the member firm be managed by an ROP. It

follows that manv branch offices of broker-dealer firms are managed

321

by persons who know little about listed ootions regulations or trading.

For example, the Ctotions Study found managers who:

. tried to understand strategies employed by
reqistered representatives under their
supervision "only once" or "not at all"
because they did not know how to analyze
options trading activity or could not
recognize the strategies being employed;

claimed to review customer options information
forms onlv randomly and then not to determine
whether options trading was suitable for the
customer involved but rather "for [the manager's]
own education";

. did not know if their firms had criteria for
determining suitability of options transactions;

. did not know how many accounts in the branch office
were trading options or approved for options trading;

. did not know whether any accounts in the office
had been rejected for options trading and relied
upon the registered representatives in tne office
to know the manager's "thoughts" on a particular
options account approval question rather than seeking
approval in specific cases;

. did not know that customer account statements were
available in a microfiche file in their own branch
offices;

. had no written supervisory orocedures for overseeing
ootions trading in their offices.

In several of the instances set out above, public customers suffered
losses that would not have occurred with adequate supervision of the
activity of registered representatives selling options. Ihe lack of
traininq of the local supervisor contributed significantly to each
oroblem.

322

When a branch manager lacks the necessary expertise to supervise

the options business of his office, he sometimes delegates supervisory

authority to a subordinate manager or even to a registered representative

who holds himself out as an expert in listed options trading. The Options

Study has reviewed a number of cases in which such delegations have

led to confusion of responsibilities or, in effect, have resulted in

the very registered representative who is most in need of supervision

be inn permitted to supervise himself. For example:

. a manaqer allowed a registered representative to perform
the manager's daily compliance function of initialing
all trading tickets in the registered representative's
own discretionary accounts;

. a manager allowed registered representatives to approve
their own customer accounts for options trading;

. one registered representative was permitted to receive and
maintain all copies of customer account records;

in one situation, a branch manager and his subordinate each
claimed that the other was responsible for the conduct of
customer suitability reviews, which were never performed;

. one manager , who felt his background in sales had not prepared
him to supervise listed options trading, turned over all super-
visory authority to his operations manager, whom he then failed
to supervise;

one branch manager who knew of a growing number of customer
complaints against one registered representative selling
options and knew of other problems in the registered repre-
sentative's accounts, left on a two-week vacation without
givina his assistant manager any instructions concerning the
supervision of this registered representative.

In several of the above instances, public customers suffered harm because

inadequate supervision, resulting from inappropriate delegation of

authority, which allowed a registered representative to engage in improper

323

conduct. Problems of delegation have been particularly serious in
some satellite or sub-branch offices, where the primary supervisor is
not on the premises.

Some firms have come to recognize that proper supervision of
registered representatives1 options activities at the local level
requires the presence of an ROP with supervisory responsibilities in
each branch. More than 25 percent of the firms in the industry group
sample now require their branch office managers to be ROP-qualif ied,
and approximately 57 percent of all the branch managers of firms in the
industry group sample are ROP-qualif ied.

While the presence of an ROP-qualif ied supervisor in each brokerage

firm's sales office would not alleviate all the options sales practice

problems which result from a breakdown in supervision, such a requirement

would be a basis for sound supervision in the local sales office.

Accordingly, the Options Study recommends:

THE SELF-REGULATORY ORGANIZATIONS SHOULD ADOPT RULES
TO REQUIRE THAT THE PRINCIPAL SUPERVISOR OF ANY
AND ALL OFFICES ACCEPTING OPTIONS TRANSACTIONS 3E
QUALIFIED AS AN ROP.

b. Compensation of local supervisors

Several conflicts of interest are inherent in the current system

of branch manager supervision. The most serious of these conflicts

spring from the method by which brokerage firms compensate branch

managers. Most brokerage firms compensate their branch managers, in

324

whole or in Dart, on the basis of the manager's own commission production
and on the orofitability of the office he manages. The following table
sets out the practices of the firms in the industry group sample with
reqard to compensating sales office managers.

COMPENSATION OF SALES OFFICE MANAGERS
Method of Compensation Percentage of Firms in Sample

Own commission production 38%

plus bonus or percentage
of office commission
oroduction

Salary olus own commission 21%

oroduction plus percentage
of office commission
oroduction

Salary and bonus 19%

Percentage of office 16%

commission Droduction

Profit participation above 3%

profit ouota for office

No response 3%

These results show that at least 78 percent of the firms in the
sample expect branch managers to look to either their own sales efforts,
or the sales commissions generated by the branches they manage (or a
combination of both) for some or all of their compensation. In addition,
91 percent of the industry group sample told the Options Study that
thev allow local sales office supervisors to service their own customer

325

accounts. These conditions offer temptation for a local manager to favor
the commission production of his office or of his own sales efforts
over the reouirements of proper supervision.

It is eoually apparent that when the branch manager spends much
of his working day servicing his own accounts, he has less time for
supervision of the activities of other salespersons and, particularly,
for the detailed financial analyses sometimes required to oversee
adeouatelv customer options trading.

The incentive provided to a local manager to favor commission production

rather than supervision is evident in the following testimony of a registered

representative regarding his branch manager's attitude toward supervising

a verv active customer account :

FXCERPT FROM TESTIMONY OF AN OPTIONS SALESMAN - November 10, 1977

LAWYER: Now, you mentioned that you discussed [this investor's]

option account with [your supervisors]...

Do you recall anything that [your branch manager] ever
told you in connection with the commissions that [this
investor] was generating?

SALESMAN:

Not really, no, just enjoy it while it lasts.

LAWYER: What did you understand [the branch manager] to mean

when he said to you, "Enjoy it while it lasts?"

326

SALESMAN: That eventually, you know, he'll probably move on to
another broker aqe firm, you know, blow himself out
of the water .

LAWYER: Was there any discussion of what could be done to

help [the investor]?

SALESMAN: Not to help, no. [The branch manager] just said that,
you know, make sure that we get the money. Okay?
Keep him posted. And I think I remember [the operations
manager] mentioning that this account may have to be
restricted because of the fact that he had now had
three purchases which he had not paid for in cash, but
had sold , you know, after the purchase , days later ,
which first was like a free riding, and after three
of those things, the account is to be restricted.
... And then [the branch manager's] comment was that
'we will never restrict the account.'

LAWYER: Did he say why?

SALESMAN: No. It was understood. There was a big — you know,
a big revenue machine .

In nearly every significant case of fraud encountered by the Options

Study, there has been a local breakdown of supervision caused, at least

in part, by the conflict of interest engendered by a manager's own

interest in commission ©reduction and his responsibilities as a supervisor

The most serious manifestation of this conflict is the tendency of

local managers to pamper large commission producers even to the point

of iqnoring clear indications that the "producer" is not properly

servicing his customers' accounts. One branch manager testified about

327

how delighted he was to have two options salesmen who were "high producer;
in his employ. He actively recruited customer accounts for them, even
thouqh he had stronq indications that both salesmen had caused and
were causing serious problems in their handling of customer accounts.

The financial inducements to humor the large commission
producer are reinforced by the manager's awareness that regis-
tered representatives generally are free to go where they please and
to choose a firm where supervisory conditions are favorable to their
ways of doing business. Since a registered representative who leaves
a firm often succeeds in taking with him many of his customers and
the commission revenue production of those accounts, a manager whose
own livelihood depends on such revenues may be disinclined toward
vinorouslv "suoervisinq" registered representatives whose activities
generate substantial commissions.

This concern, not to lose a "big producer," is reflected in the

following warning memorandum concerning the second largest options

revenue commission producer in a major brokerage firm. In this

memorandum, which was not heeded, the chief compliance officer of

the firm told top management:

I asked [the branch manager] if he reviewed the
— monthly statements that were sent to him
and he said "Yes, I just sign them and pray."
Be has made no effort to understand the activity

328

in [this registered representative's] accounts.
He is clearly afraid that if he questions [this
registered representative] , [the registered
representative] will resign and go to another
firm.

Some manaqers have designated large commission producers "options co-
ordinators" or "options oroduct leaders", apparently in order to placate
them, and then have failed to supervise their activities. Che local
suDervisor refused to believe the problems that continually emerged
concerning a team of registered representatives who sold exotic options
orograms, telling customers who complained that their complaints had
no substance because "there would be red lights flashing and warning
bells going off all over the place" if their complaints were true.

The problems caused by the effects upon sales office managers of
the ccmnensation structure are very difficult to control by regulation.
The Qotions Study believes, however, that a firm's overall policies
concerninq its sales practices set the tone and the standards by which
all the firm's employees conduct themselves. If the management of
the firm makes clear that a branch's performance will be measured not
-just by commission production, but by customer satisfaction and fair
treatment, the method by which branch managers are compensated would
be a less serious impediment to sound supervision than it now appears
to be.

c. Attitude of the Broker-Dealer Firm Toward Supervision

The Options Study has found that the attitude of a brokerage
firm toward supervision either reinforces sound supervisory procedures

329

or, if misdirected, can seriously weaken the resolve of branch managers
to suoervise. She Options Study came across several cases in which
prevail inq attitudes within the firm undermined a branch manager's
efforts to control a "biq producer" and permitted the misconduct of
the reqistered representative to continus. In one case, where the branch
manaqer was aware of compliance problems concerning one team of options
salesmen, he was also confronted by a letter from a regional sales
manaqer of the firm to one of the team members congratulating him
for recent production figures and expressing appreciation for his
"fine efforts." In another case, where a branch manager expressed
concern about the activities of two options producers to management
at the heme office, his warnings were ignored because of the home
office's "high reqard" for these large commission revenue producers.

Two case studies reviewed by the Options Study particularly
illustrate how a firm's attitude toward the supervision of a registered
representative who produces larqe commissions may permit serious mis-
conduct to qo unchecked.
CASE A

For more than six months, a large commission producing registered
representative was nominally supervised by a vice president of a major
brokerage firm who was located at a different address than the registered
representative. The registered representative was given office space
adjacent to special communications equipment, his own telex terminals

330

and his own alphanumeric code. Treated as the functional equivalent

of an entire branch office, this registered representative, not his

supervisor, was sent the supervisor's copy of customer statements

and account analyses.

After several months of extremely active trading involving

ootions in the registered representative's accounts, the vice president

assianed to "supervise" the salesman warned his own superiors:

[This registerered representative] cannot be effectively
supervised from [his current location] ....

Althouqh our basic gut feeling about [this registered
representative] is good, his entire business is concentrated
in [several] accounts, and there is no doubt in our
minds [he] will bend over backwards to give these
[several] accounts whatever they want. As a result,
our exposure is considerable....

We have no papers as of yet for [a major] account,
but understand that new account papers are on the
wav ....

[The registered representative's] business is so large and
complex, that daily on-the-spot supervision must be conducted.

The same memorandum then set forth a discussion of the profitability

of the reqistered representative's activities for the year to date,

annualizing figures to determine a "gross production" of $650,000

and an approximate "profit to the office" of $150,000. The memorandum

concluded :

1. Fbr the time being at least, we want [this registered
representative] .

2. We want him only if we can control him.

3. We must keep him happy..."

331

Two months later, the same vice president again warned his

superiors about this same registered representative:

... my conclusion — that [this registered representative]
cannot be effectively supervised under present conditions
has not changed, and is based upon the following observa-
tions:

[This registered representative] needs the brokerage
journals, daily transaction analyses, commission sheets,
two sets of customer confirms, statements, etc., to
effectively conduct his business. For that reason he
will not release any of the foregoing, and since duplicates
are not available, it's an impossible job to determine what
he does over there (and, for that matter, how he does it)....

DesDite these warnings, no effective steps were undertaken to

supervise this registered representative's activities for another

three months. Curing this period, the registered representative

was able to perpetrate a complex fraud on his options customers to

whom his brokerage firm eventually paid several million dollars to

settle lawsuits.

CASE B

In March 1978, Mr. X was promoted to be manager and resident

supervisor of a branch office of a major brokerage firm. About this

time, Mr. X, one of the largest options commission producers in the

firm, was featured by a national financial columnist as an options

expert whose exotic options strategies had returned up to 20 percent

on eouity for pleased options customers during the just past year. The

article went on to set out some of Mr. X's recommended options trades.

Unknown to readers of this column and to almost all of Mr . X's own

options customers, Mr. X's options accounts were actually in disarray as

332

a result of excessive trading and Mr. X's mismanagement. Ultimately,
several of Mr. X's customers sued him and his employer for fraud
and recovered substantial judgments.

Mr. X had been made sales manager and then a branch manager of the
firm even thouqh he had proved to be a constant supervision problem.
Gomoliance oersonnel had warned Mr. X of excessive trading in his
customer accounts, had asked in vain that he inform his customers
of their account eauity, and had requested, without success, that he
tell the firm how many of his options accounts were discretionary.
These problems had also been brought to the attention of senior
management of the firm.

The top manaqement of the firm, concerned that strict supervision
over Mr . X might drive him out of the firm, had ignored repeated warnings
about bis performance from the compliance office and instead attempted
to resolve amicably the problems which Mr. X had caused for his super-
visors. For more than a year, the firm gently attempted to bring Mr.
X and his customer options accounts under supervisory control. Management
finallv resolved the problem of supervising Mr. X by promoting him
to branch manager. In this new position, Mr. X had supervisory control
over his own activities and over the activities of several younger
salesmen whose sales efforts were almost exclusively in listed options.
At least one of these salesmen was subsequently the subject of options-
related customer complaints.

333

The Options Study believes that sound selling practices require

top management of a brokerage firm to be committed to a program of

effective supervision and to demonstrate its support for such a program.

A detailed program of supervision which incorporates the recommendations

in this selling practices chapter as minimum standards could form the basis

of an effective supervisory program. Accordingly, the Options Study

recommends :

THE SELF-REGULATORY ORGANIZATIONS SHOULD DEVISE A
UNIFORM DETAILED PROGRAM FOR SUPERVISION OF OPTIONS
TRADING WITHIN MEMBER FIRMS WHICH WOULD ESTABLISH
MINIMUM SUPERVISORY STANDARDS AND PROCEDURES
AND WHICH WOULD ADDRESS THE ISSUES RAISED IN, AND
INCORPORATE THE RECOMMENDATIONS OF, THIS CHAPTER
AMONG THOSE STANDARDS AND PROCEDURES.

5. Home Office Supervision

For a broker-dealer firm's overall program of supervision to be
acceptable, the headquarters office as well as the branch offices must
have personnel who can oversee and support the work of supervisors at
the sales offices. Certain types of options-related compliance matters,
such as periodic surveillance of customer options transactions and the
overview of options trading in a branch, are more appropriately performed
by home office personnel properly qualified in options.

As already noted, the rules of the options exchanges require that
member firms designate a principal or "Senior" Registered Options
Principal ("SROP"), who is an officer or general partner of the firm,
to be responsible for the supervision of options customer accounts.

40-940 O - 79 - 24

334

The central, indeed unique, role assigned to the SROP in a firm's
or oar am of ootions compliance requires that the person designated
as SROP not be given conflicting duties and responsibilities. Yet,
many firms appear to regard SROPs more as sales promotion managers
than as compliance officers. Well over half the firms in the industry
nrouo sample responded on the Options Study questionnaire that they
assign to their SROP the job of heading the firm's options marketing
program (56 percent). More than two-thirds of the firms in the sample
assian to their SROP some selling function (68 percent).

The distraction of sales promotion responsibilities can prevent
an SROP from focusing his complete attention on supervision of the
firm's options activities. Moreover, if, as options sales manager,
he is competina with other "product managers" (commodities, annuities,
etc.), for the attention of registered representatives, he, like his
branch manager counterpart, may be more interested in sales figures
than in sound sales practices.

The co-opting of the SROP for sales promotion purposes, however,
would not be of particular concern if someone else of stature within the
firm, who had demonstrated options expertise, such as an ROP-qualified
compliance officer, were assigned significant supervisory responsi-
bilities over options accounts. Ifewever , in almost half of the firms
surveyed by the Options Study, the SROP was not the firm's chief compliance
officer, nor was the firm's chief compliance officer ROP-qualified.

335

In more than one quarter of the industry group sample, no senior official

of the firm with options expertise had primary options compliance

responsibilities, since the SROP was involved in his firm's options

marketing effort, and the chief compliance officer was not ROP-qualif ied.

In many of these firms, not a single home office compliance employee

was ROP-qualif ied.

Having ROP-qualif ied individuals supervise options accounts at

the home office level is less important if the firm's branch office

managers are required to be ROPs. As noted above, however, only a

little more than one quarter of the firms in the industry group sample

now require their branch office managers to be so qualified. And almost

one quarter of the responding firms (1) do not require branch office

managers to be ROP-qualif ied; (2) do not have any ROP-qualif ied home

office compliance personnel; and (3) assign to their SROP significant

sales functions. To ensure sound options selling practices by the

firm and its registered representatives, a policy-level compliance

officer is needed at a firm's headquarters office to lead the

program of supervising — not promoting — the firm's options

bus iness .

Accordingly, the Options Study recommends:

THE RULES OF THE SELF-REGULATORY ORGANIZATIONS
SHOULD BE AMENDED TO REQUIRE THAT BROKERAGE FIRMS
ASSIGN AT LEAST ONE HIGH RANKING PERSON WHO IS
ROP-QUALIFIED TO PERFORM, OR TO DIRECTLY SUPERVISE,
HOME OFFICE COMPLIANCE PROCEDURES RELATING TO OPTIONS.
THE RULES SHOULD PROVIDE THAT, ABSENT A CLEAR
SHOWING OF COMPELLING CIRCUMSTANCES, THIS PERSON
HAVE NO SALES FUNCTIONS, DIRECT OR INDIRECT,
RELATING TO OPTIONS OR OTHERWISE.

336

C. SUITABILITY

1. Introduction

Durinq 1978, the Commission charged a major broker-dealer firm and
several of its employees with violations of the anti-fraud provisions
of the Federal securities laws in connection with the options selling
activities of several- of the firm's registered representatives. One
team of registered representatives from this firm had persuaded its
customers to engage in a program consisting of large-scale writing of
uncovered options that were near-the-money, an extremely risky form of
ootions trading activity. As outlined below, many of these customers
did not have the financial means, sophistication, or investment objectives
to justify exoosure of a substantial portion of their assets to an uncovered
writing program:

Customer A — a retired minister in his early 80 's. He had an
annual income of between $10,000 and $25,000 and a net worth of
$25,000 to $50,000. His recorded investment objectives were
dividend income and "additional income from sale of uncovered
ootions." There was evidence that he was mentally unstable.
He invested $30,500 and lost $23,700 in six weeks.

Customer B — an unemployed widow. She had an annual income of
under $10,000 and a net worth of approximately $85,000, and
relied on the expected income from her options account to
meet her living expenses. Her prior investment experience
consisted of mutual fund purchases, blue chip stocks, and a
small amount of covered writing. She placed stock worth
$22,000 into the account and lost $19,000 in six months.

Customer C — a retired post office worker. He had an annual
income of approximately $10,500 and a net worth of less than
$50,000. He invested $16,700 and lost $8,600 in three weeks.

Customer D — a computer designer . He had an annual income of
$25,000 and less than $25,000 in estimated net worth and lost
nearly all of his $10,770 options investment.

337

. Customer E — a colleqe student. She needed income fron her
investment to complete her colleqe education. She had a joint
account with her father, a marketing representative, whose job
took him out of the country for extended periods of time. The
nair suffered a total loss of their $25,000 joint account in one
and a half months.

. Customer F — a customer, with a severe heart condition whose
objectives and investment experience were conservative. He
transferred into his options account a portfolio consisting
of investments in conservative stocks and an income-oriented
mutual fund. The customer lost $9,000 of the $14,000 invested
in two months.

These examples illustrate a major regulatory concern which has
develoDed from listed options trading — options trading is unsuitable
for manv of the oublic customers who engage in it. The Options Study
found, throuahout its investigation, numerous customers who had been
solicited for listed options trading even though, by any reasonable
standards, they had neither the sophistication to understand, nor the
financial resources to bear, the risks they were undertaking.

None of the customers in the cases above satisfied the suitability
standards of the self-regulatory organizations with regard to uncovered
oDtions trading; none of them even satisfied the brokerage firm's
own minimum liouid asset and annual income requirements for customers
who engaae in risky options trading. The firm's general warning to
its registered representatives against involving widows, senior citizens,
and other classes of conservative investors in the more speculative
tyoes of options strategies was to no avail.

338

A number of factors contributed to the failure of this brokerage
firm to protect the interests of its customers. The registered repre-
sentatives involved were untrained, unscrupulous and unsupervised;
the firm overemphasized commission revenue production; the local
and home office supervisors were either unwilling or unable to
suoervise oroperly registered representatives selling options.
These problems could not have occurred without serious flaws in
the firm's suitability control procedures.

2. The Suitability Doctrine

The doctrine that a securities recommendation must not be unsuitable
for a customer in liqht of his financial resources and investment
obiectives is a key element in a broker-dealer 's obligation to deal
fairly with its customers. The doctrine requires that a broker-dealer
and its registered representatives recommend for the firm's customers
only those securities transactions which they reasonably believe are
suitable in light of the customer's financial situation and needs. 15/
The suitability reauirement does not attempt to make a registered
representative, or the brokerage firm for which he works, an insurer
of favorable investment performance. It does, however, obligate the
brokeraae firm and registered representative to make sure that any
recommendations made are done so with the customer's interests and
characteristics uppermost in mind. As such, the doctrine, and the

15/ See generally R. MUNDHEIM, Professional Responsibility of Broker-
Dealers: The Suitability Doctrine, 1965 DUKE L.J. 445 (1965)
[hereinafter cited as MtNDHEIM] ; N. WOLFSON, R. PHILLIPS & T. RUSSO,
REGULATION OF BROKERS, DEALERS AND SECURITIES MARKETS (1977), 1| 2.08
[hereinafter cited as WOLFSON] .

339

self-requlatory organization rules which codify it, are meant to serve
as a fundamental protection for customers who rely on the judgment and
exDertise of their brokerage firms and their registered representatives.

Manv customers have difficulty comprehending the risks involved
in ontions tradinq, and, out of necessity, develop a total dependence
upon the advice, of their reqistered representatives. In these circum-
stances, where options customers frequently cannot make informed
decisions concernina their own accounts, the responsibility of registered
representatives to assure that recommendations made to customers are
suitable is all the more meaningful.

a. Traditional concepts of suitability

The suitability doctrine originally developed as an ethical standard

of business conduct and was first set down in the 1930s as a guideline

to the NASD Rules of Fair Practice. As now incorporated into the

NASD rules, it states:

[I]n recommending to a customer the purchase, sale or exchange
of any security, a [broker-dealer] member shall have reasonable
qrounds for believinq that the recommendation is suitable for
such customer upon the basis of the facts, if any, disclosed by
such customer as to his other security holdings and as to his
financial situation and needs. 16/ (Bmphasis added.)

The NASD suitability rule, therefore, requires that member firms have a

reasonable basis for believing that a recommendation is suitable, but

does not recuire specifically that firms inquire into the customer's

financial circumstances and investment objectives. 17/

16/ NASD Rules of Fair Practice, Art. Ill, § 2, NASD MANUAL (OCH) 1| 2152.

17/ Ibid. , "Policy of the Board of Governors", (discusses NASD policies
relating to this rule).

340

The NYSE and AMEX have not adopted rules which directly address
suitability of recommendations to buy or sell listed stocks or bonds.
However , both exchanges do impose on member firms a duty to use "due
diliqence to learn the essential facts relative to every customer." 18/
Althouqh this requirement, to "know your customer", might have been
desiqned oriainally to protect member firms against poor credit risks,
it has been interpreted over the years to serve also as protection for
customers against unsuitable recommendations. 19/

In 1967, the Commission adopted its own suitablity rule, applicable

to broker aae firms which are not members of the NASD or of any national

exchanqe. Known as the "SECO" suitability rule, it provides that:

Every nonmember broker or dealer and every associated
person who recommends to a customer the purchase, sale
or exchange of any security shall have reasonable grounds
to believe that the recommendation is not unsuitable for
such customer on the basis of information furnished by
such customer after reasonable inquiry concerning the
customer's investment objectives, financial situation
and needs, and any other information known by such broker
or dealer or associated person. (Emphasis added.) 20/

Unlike the NASD rule, the Commisssion's rule imposes on brokerage firms

a soecific affirmative duty to inquire into a customer's circumstances.

18/ Rule 405, 2 NYSE GUIDE (OCH) 11 2405; Rule 411, 2 ASE GUIDE (CCH)
II 9431.

19/ WOLFSON, at \\ 2.08[1]; MJNDHEIM, at 451 n.14 and 463 n.54.

20/ Securities Exchanqe Act Rule 15bl0-3, 17 C.F.R. § 240.15bl0-3 (1977)

341

b. Suitability developed for listed options

When the CBOE was established in 1973, it adopted a suitability rule
which included the traditional standards of suitability and parallelled
the Commission's own rule. Therefore, like the Commission's rule, the
CBOE rule imposes on brokerage firms a specific affirmative duty to
conduct reasonable inquiry into a customer's circumstances and to have
reasonable qrounds for believing that a recommendation is not unsuitable
for the customer .

In addition, the CBOE rule included additional and more stringent
suitability standards to recognize the potentially greater risks inherent
in uncovered call writing transactions. When the rule was amended in 1977
to include outs, these standards were also made applicable to recommenda-
tions for put writing transactions. These additional requirements provide
that:

[A] recommendation to a customer of [writing a put or an
uncovered] call ootion contract, shall be deemed un-
suitable for the customer unless, upon the information
furnished by the customer , the person making the recom-
mendation has a reasonable basis for believing

that the customer has such knowledge and experience in
financial matters that he may reasonably be expected to
be capable of evaluating the risks of such transaction,
and such financial capability as to be able to carry such
position in the option contract. 21/ (Emphasis added.)

The most significant difference between this standard and the tradi-
tional standard applicable to supposedly less risky options transactions

21/ Rule 9.9, CBOE GUIDE (CCH) 1| 2309.

342

is that this new standard requires that the firm have a reasonable
basis for believing that the customer is sophisticated enough in
financial matters to understand the risks of uncovered call writing
and put writing strategies. The rule relating to other options
strateqies requires no such finding.

Other self -regulatory organizations have adopted suitability
rules similar to the CBOE's, both with respect to general options
trading and to the more risky uncovered call writing and put writing
strategies. 22/

Tne Options Study believes that the current suitability standards

applicable to options transactions should be strengthened in the

following ways:

(1) A Finding that the Customer is Capable of Evaluating
the Risks of Options Transactions

The current options prospectus states on the cover page in

bold- face type:

Both the purchase and writing of Options involve
a high degree of risk and are not suitable for many
investors. Such transactions should be entered into
only by investors who have read and understand this

22/ Rule 923, 2 ASE GUIDE (CCH) 1| 9723; Art. XLVM, Rule 5, MSE
GUIDE (CCH) 1(2115; Rule X, Sec. 18(c), PSE GUIDE (CCH)
11 4993; Rule 1026, PHLX GUIDE 11 3026. Unlike the CBOE rule,
the suitability standards of the other options exchanges
apply to all transactions in put or uncovered call writing,
whether or not recommended. Tnis means that the firm must
refuse to effect any unsolicited transaction in either put
or uncovered call writing unless the firm has a reasonable
basis for a suitability determination.

343

prospectus and, in particular, who understand the
nature and extent of their rights and obligations
and are aware of the risks involved. (Emphasis added.)

As discussed above, the options exchanges do not require that a

broker-dealer recommend ing options transactions to a customer have

a reasonable basis for believing that the customer understands the

risks of the recommended transactions, except when the particular

recommendation or transaction is to write uncovered calls or to write

Dut ootions.

The Ootions Study believes that a customer should be made aware,

on an on-going basis, of the risks of any and all options transactions

undertaken bv the customer and that a brokerage firm should not be

oermittei to recommend any options transaction to a customer unless

the firm reasonably believes that the customer is capable of both

evaluating the risks and bearing the financial burden of those risks.

Accordinaly, the Options Study recommends:

THE SELF-REGULATORY ORGANIZATIONS SHOULD REVISE THEIR
OPTIONS CUSTOMER SUITABILITY RULES TO PROHIBIT A BROKER-
DEALER FROM RECOMMENDING ANY OPENING OPTIONS TRANSACTIONS
TO A CUSTOMER UNLESS THE BROKER-DEALER HAS A REASONABLE
BASIS FOR BELIEVING THE CUSTOMER IS ABLE TO EVALUATE
THE RISKS OF THE PARTICULAR RECOMMENDED TRANSACTION
AND IS FINANCIALLY ABLE TO BEAR THE RISKS OF THE RECOMMENDED
POSITIONS.

(2) An Affirmative Requirement to Obtain Suitability
Information Before Recommendations are Made

A broker-dealer 's duty of "reasonable inquiry" under the suitability

rules requires that the firms at least ask the customer for suitability

information. If a customer refuses to furnish this information, the

344

ririn must, nevertheless, nave " reasonable y rounds" on wnicn to base a
suitability uetenuination.'t

Tne CdOE yuiaelines max.e clear tnat " [mjakiny a recommendation
witnout Knowmy tne customer's essential tacts or otner inionnation
win result in tne recommendation Deiny unsuitable. " 23/ However,
tnese yuidennes do penult options transactions to be recommended
to a customer wno reiuses to turnisn suitability lntormation, pro-
vided tne rinu nas otner lntormation mdicatiny tnat tne recaiimended
transaction is not unsuitable tor the customer.

Estimating suitability lntormation tor a customer wno retuses
to turnisn tnis intonation can result in the same problems that
occur wnen a reyistered representative tails to inquire into a
customer's bacKyrouna. Unless sutticiently comprehensive customer
mtomiation is actually ootained, suitability detenninations
cannot oe maae.

Accordingly, to clarity and strenythen tirms' obligations to

outain suitaoility inrormation tor customers, tne Options Study

recommends :

THE RULES OF THE SELE-REGULATORY ORGANIZATIONS

SHOULD dE Ai-iENDED 'lO PROHIBIT FIRMS FROM REGOM-

inENDlNG OPENING OPi'IONS TRANSACTIONS ID ANY CUSTOMER WHO

16/ CbOE Educational Circular ffb, at 10.

x tor a more detailed discussion of tne amount of information

necessary to torm reasonable yrounds for a suitability detennation ,
see p. tz below.

345

REFUSES TO PROVIDE INFORMATION, AND FOR WHOM THE
FIRM? DO NOT OTHERWISE HAVE INDEPENDENTLY VERIFIED
INFORMATION SUFFICIENT FOR THE SUITABILITY
DETERMINATION.

c. Account opening rules

The existing suitability rules require that a brokerage firm
ask its customers for certain information and use the information
obtained, alonq with any other information known about the customer,
in determining whether recommended options transactions are suitable
for that customer . In an attempt to assure that such information is
obtained and used, all the options exchanges have adopted rules which
reouire that before a customer is permitted to trade options, his
brokeraqe firm must make an initial determination that listed options
tradinq is not unsuitable for him.

The CBOE's "know your customer" rule is a typical options exchange

account opening rule. It requires that suitability information be

obtained, recorded, and used by a brokerage firm in determining

whether to aDDrove the account for options trading:

In approving a customer's account for options transactions,
a member organization shall exercise due diligence to learn
the essential facts as to the customer , his investment
objectives, financial situation and needs. A record of this
information shall be maintained by the member organization
and, based upon such information, a Registered Options
Principal who is an officer or partner of the member organi-
zation shall approve in writing the customer's account for
options transactions .... 24 /

24/ Rule 9.7(b), CBOE GUIDE (CCH) 1! 2307.

346

Other self-requlatory organizations have adopted similar account
opening rules. 25/

d. Summary

In conjunction with account opening requirements, current suitability
standards aoplicable to a firm's initial determination of the general
suitability of oDtions trading for a customer, and of specific trans-
actions after the customer is approved for options trading, can be
summarized as follows:

(1) The brokerage firm qenerally must acquire, use and maintain
a current record of information regarding the customer's background,
financial resources and investment objectives.

(2) Using the information thus acquired, the brokerage firm must
make three determinations:

(a) does the customer have sufficient financial resources to
bear the risks of a recommended transaction;

(b) are the risks of a recommended transaction appropriate in
liqht of the customer's investment objectives; and

(c) with regard to recommendations of put or uncovered call
writing transactions, is the customer sufficiently sophisticated

to enable him to corner ehend the risks involved in such transactions.*

25/ Rule 921, 2 ASE GUIDE (OCH) 11 9721; Art XLVIII, Rule 3, MSE GUIDE
(CCH) 11 2113; Rule X, Sec. 18(b), PSE GUIDE (CCH) 1| 4993; Rule
1024(b), IHLX GUIDE (OCH) H 3204.

* As noted above, the Options Study believes this requirement should
be made applicable to all recommended transactions.

347

The Options Study has found violations of these standards throughout
the industry.

3. Acquisition of Information
a. Accuracy

A firm's first step in making a proper suitability determination
is to obtain the- required information from its customers. This information
is then usually transferred to an account information form and retained
by the firm.

Althouqh the reouirement that firms obtain this information is
explicit in the self-regulatory rules, firms nevertheless evade it
in several ways. First, a majority of the firms surveyed by the
Ootions Study oermit registered representatives to estimate customers'
financial suitability information when opening accounts for options
tradinq, rather than insisting that the registered representative
obtain exact information from his customers. Second, when existing
securities accounts are converted to options trading, many firms
have a practice of simply transferring the information on the customer's
or in in al, and often outdated, account opening card to the new account
aDoroval form for options. Finally, registered representatives may
deliberately overestimate their customers' financial status in order
to gain from their supervisors approval of those accounts for options
tradinq .

348

As a result of these practices, it is not uncommon to find inaccurate
suitability information about a customer contained in the files of
broker-dealer firms. The Options Study found one situation in which
a reqistered representative had estimated his customer's annual income
at $15,000 to $20,000 and her net worth at $70,000, when in fact she
earned $12,000 and her entire net worth consisted of the $20,000 equity
in her home. In another case, one set of firm records showed a customer's
net worth as $250,000 while another set of the firm's documents showed
the same customer's net worth as only $30,000.

One reqistered representative testified that she had estimated a
client's income to be substantially hiqher than it actually was and
that, had she known the customer's true financial situation, she would
have urqed a more conservative investment approach. Another registered
representative admitted that he never asked one of his customers for the
customer's net worth but instead made a suitability determination based
on a "first impression" of the customer's business knowledge, dress,
and sophistication in discussing securities and strategies. Unknown
to the registered representative, this customer was a retired medical
consultant with limited resources and an annual income of only $6,000
per year. The registered representative also mistakenly assumed the
customer's investment objective to be capital gains instead of income.

Inaccurate suitability information in a firm's files prevents a
firm's supervisory personnel from fulfilling their responsibility to
make reasoned determinations of the suitability of options trading for

349

the firm's customers qenerally and for particular options transactions.

As a conseouence, customers can become involved in options transactions

totally unsuitable to their means. A sample of such cases includes:

. an 18 year old student away at college who was allowed to trade
listed ootions and lost approximately $2,200 of tuition money.
This student had been turned down for options trading in his
hometown office of the same firm by a registered represent-
ative who handled his parents' securities account;

. a welfare recipient who was engaged in a strategy of selling calls
covered only in oart by warrants on the underlying stock;

. a widowed, retired school teacher who was allowed to engage
in advanced options strategies from which she lost one half
of her life savings.

Manv customers never see the financial and other data which

sunoosedly form the "reasonable basis" for a determination of their

options suitability. Inaccurate information about options customers

might be corrected if all firms enabled customers to verify personally

their account information. Although some firms either: (1) send a

coov of the suitability information to the customer for his verification,

or (2) check with a credit agency, bank or other credit reference

in order to determine the veracity of customer suitability information,

many firms surveyed by the Options Study make no such attempt.

Tb correct this situation, the State of Wisconsin has required

that firms furnish every customer with a conformed copy of all agreements

between the firm and the customer and with a copy of the prescribed

customer information form. 26/ In order to conform with the V\/isconsin

26/ Wise. Admin. Code § 4.05(7).

40-940 O - 79 - 25

350

statutes, several brokerage firms send a copy of the customer information
forms to their customers in Wisconsin, but have chosen not to expand
this practice to customers located in other states.

The Options Study believes all firms should be required to verify
the accuracy of such information by sending a copy of the completed
form to the options customer. It is important, however , that procedures
for verification not be regarded as a means for lessening the broker-
dealer's responsibility to obtain accurate and comprehensive suitability
information.

In an effort to imrrove the accuracy of recorded suitability

information, the Options Study recommends:

THE SELF-REGULATORY ORGANIZATIONS SHOULD MEND
THEIR OPTIONS ACCOUNT OPENING RULES TO REQUIRE TEAT
(1) THE MANAGEMENT OF EACH FIRM SEND TO EVERY NEW
OPTIONS CUSTOMER FOR HIS VERIFICATION A COPY OF
THE FORM CONTAINING THE CUSTOMER'S SUITABILITY
INFORMATION; AND (2) THE SOURCE (S) OF CUSTOMER
SUITABILITY INFORMATION, INCLUDING THE BASIS
FOR ANY ESTIMATED FIGURES, BE RECORDED ON THE
CUSTOMER INFORMATION FORMS.

b. Sufficiency

Not only is a firm's information about its customers sometimes

inaccurate, it can also be severely lacking in content. Although

none of the options suitability rules specify the amount of information

necessary to form a reasonable basis for a suitability determination,

"Educational Circular #6" prepared by the CBOE suggests the type of

customer information which a firm should record in writing:

351

Inauiry should attemot to determine pertinent facts
about the customer . Some facts which may be considered
pertinent are the client's marital status, dependents,
occupation, maior sources of income, investment objec-
tives, net worth, investment experience, and ability
to understand and evaluate the risks of options trans-
actions. A written record of the essential facts must
be maintained by the firm 27/

Attached to the CBOE circular is a checklist of information that the firm
miqht wish to obtain during its customer inauiry, such as occupation;
net worth; dependents; annual income; past investment experiences in both
ODtions and other securities ( specif iying size, frequency of transactions,
type of transactions, and years of experience); and investment objectives.

The AMEX publishes a similar checklist which, in addition to the infor-
mation reouired by the OBOE, suggests that a firm distinguish between a
customer's income from employment and his income from other sources;
identify whether the customer rents or owns his own home; and obtain the
customer's net worth exclusive of family residence, as well as his liquid
net worth, insurance, and previous and current brokerage accounts (including
type and deqree of activity). 28/ The AMEX guidelines require, in
addition, that the customer's refusal to furnish all the information
necessarv for account approval be noted on the customer's account form. 29/

27/ CBOE Educational Circular #6, at 2.

28/ AMERICAN STOCK EXCHANGE, ATTACHMENT TO REGULATORY GUIDELINES FOR
CONDUCTING A PUBLIC BUSINESS IN AMEX LISTED OPTIONS (PUTS AND
CALLS), (MAY, 1977) [hereinafter cited as AMEX REGULATORY GUIDE-
LINES ] .

29/ Id. at 4.

352

Evidence suqqests that firms do not follow these exchange guidelines.
In some cases, the oroblem might be solved by a simple exercise in drafts-
manship, in that some firms' account forms for options customers do not
have places for the transcribing of information specified by the self-
regulatory organizations. For example, some forms do not have a space
in which a customer's net worth or occupation can be disclosed, and many
do not provide room to record liquid net worth, dependents, or previous
investment exoerience.

In other cases, however, firms seem to shield themselves from information
about customers which miqht bear on suitability. Registered representatives
are not encouraged or required to be candid about a prospective customer's
circumstances even though registered representatives are often in possession
of uniaue suitability information. The Options Study reviewed several
situations where this lack of candor prevented critical facts concerning
a customer's circumstances from being revealed to the supervisors who
had to make the appropriate suitability determinations. For instance,
the Options Study found the following examples of customers whose information
forms suggested financial resources for options trading, but who had
other, unrecorded problems which were generally known to their registered
representatives and which raised questions about the suitability of
options for them:

. A retired couple with assets of more than $100,000 and income
of $12,000, but where the husband was fully disabled, was
receivinq outpatient mental care, and where the couple had
an adult retarded child fully dependent on them;

353

A woman who appeared to have adequate resources to engage
in options trading but who appeared to be mentally unstable,
extremely nervous and confused, and had no understanding
of financial matters nor family or friends to help her;

A twenty-year old who appeared to have substantial assets, but
who was completely unsophisticated in securities matters and
whose net worth consisted of an inheritance resulting from
the death of both parents and upon which he depended for
income ;

Several customers with varying financial resources and
prior securities investment experience, but who spoke no
English;

. Several investors who appeared to have substantial

assets to invest, but who were widows with small children
and whose assets were a family house and their husbands'
life insurance proceeds.

In other cases, registered representatives did not completely
fill out the suitability forms. A recent examination at one major
retail brokeraqe firm revealed that 69 percent, or 62 out of the 90
sampled options customer information forms, were lacking information
as to net worth, annual income or investment objectives. Similarly,
an NASD survev indicated that some of its members have failed to maintain
sufficient suitability information.

Firms sometimes argue that incomplete records of suitability infor-
mation do not necessarily indicate that the firm does not have complete
information. Rather, they urge, the account may have been approved on
the basis of information not disclosed on the form. But failure of
a firm to record all of the pertinent information upon which a suitability
determination is based makes virtually impossible the supervisor's task

354

of adeouately reviewinq an office's compliance with account opening
and suitability standards. In addition, without properly recorded
suitability information, the self-regulatory organizations cannot
detect suitability or account opening abuses occurring within member
firms.

Several brokerage firms allocate space on their account opening
or account information forms for the registered representative to note
certain matters of relevance to the firm's promotional efforts, such as
how the account was acquired and whether to send various solicitation
materials to the customer. Accordingly, it should not be burdensome
to reauire that brokeraqe firms use customer information forms to
obtain the suitability information already recommended by exchange
quidelines and to provide space on the forms where the registered
representative must record any special matters which bear on a particular
customer's suitability.

In order to assure more diligent inquiry into a customer's background
for suitability purposes, the Options Study recommends:

TOE SELF-REGULATORY ORGANIZATIONS SHOULD AMEND
THEIR OPTIONS RULES ( 1 ) TO PROVIDE A STANDARD OPTIONS
INFORMATION FORM WHICH REQUIRES THAT BROKER-DEALERS
OBTAIN AND RECORD SUFFICIENT DATA, AS SPECIFIED BY THE
RULES, TO SUPPORT A SUITABILITY DETERMINATION; (2) TO
REQUIRE FIRMS TO ADOPT PROCEDURES TO INSURE THAT
ALL THE INFORMATION ON WHICH ACCOUNT APPROVAL
IS BASED IS PROPERLY RECORDED AND REFLECTED IN
THE FIRM'S RECORDS.

355

c. Timely review of suitability information

Exchange rules require that an account be approved for options

trading before a firm accepts any options order from a customer. The

account must be approved in writinq by an ROP who is an officer or

oartner of the firm, but in the case of a branch office:

an account may be approved for options transactions
by the mahaqer of such branch offices, in which event
the action of the branch office manaqer shall within a
reasonable time be confirmed by the Registered Options
Principal. 30/

To comely with this reouirement, many firms have their registered

representatives fill in the customer information form which, along with

the other account opening documents, is reviewed by the branch manager

who approves the account for trading. But the manager is not always

an ROP, and he does not always have sufficient options expertise to

nrooerly evaluate the customer information for suitability purposes.

Although the home office ROP may eventually reject the account or limit

the account's trading to certain options strategies, the account is,

meanwhile, permitted to trade options and may be engaging in unsuitable

transactions. In some instances, several months may pass before an

ROP reviews the account.

The Ootions Study believes that the recommendation in Subchapter "8"

of this chapter, "Supervision of Accounts", that all branch managers

30/ Rule 9.7(b), CBOE GUIDE (CCH) 1| 2307.

356

be ROP Qualified, may alleviate the problem of untimely review by a
oualified employee for approval of new customers for options trading.

4. Problems of Continuing Supervision

h firm's responsibilities regarding suitability do not end after it
has made the initial suitability determination and has permitted a customer
to ODen an options account and commence options trading. Exchange rules
reouire the firm to make continuing suitability determinations with regard
to each recommended options transaction. In addition, the rules of all
options exchanges, other than the CBOE, also require a similar determination
with regard to all put writing or uncovered call writing transactions,
whether or not recommended, lb fulfill these responsibilities, firms
need: (1) to assure that suitability information is appropriately updated;
(2) to establish adeauate account review procedures; and (3) to maintain
customer suitability records in locations which assure their availability
for use .

a. Current suitability information

Information obtained from a customer at the time an account is opened
freouently becomes outdated for a variety of reasons. As a customer
continues to trade listed options, his increased knowledge and understanding
of the risks involved in options trading may help alter his investment
objectives and, therefore, the suitability of various types of options
trading for him. In addition, a registered representative's relationship

357

with his customer may develop over a period of time, enabling the regis-
tered representative to learn additional information about his customer's
financial situation and investment objectives. And, of course, the
financial resources of customers may change with time.

Rarely, however, are customer account opening forms updated to
reflect changes in the customer's financial information, investment
objectives, or financial sophistication. In almost all firms surveyed
by the Options Study, account opening documents are reviewed to assure
that they contain current information only when a serious question
arises concerninq the account.

Accordingly, the Options Study recommends:

THE SELF-REGULATORY ORGANIZATIONS SHOULD AMEND THEIR
RULES TO REQUIRE THAT MEMBER FIRMS SEMI-ANNUALLY
CONFIRM THE CURRENCY OF CUSTOMER SUITABILITY
INFORMATION.

b. Account review procedures
As discussed in subchapter "B" , "Supervision of Accounts", most
firms traditionally have placed primary responsibility for supervision
of customer accounts on their branch office managers where the incentive
to supervise may be absent, and the manager's understanding of options may
he in doubt. Even where the manager is competent and properly motivated,
however, the task of performing adequate account reviews without assistance
is difficult, particularly in offices which do a high volume of options
business. Some firms have recognized the need to provide help to branch

358

manaqers and have developed computer-assisted programs to support
branch managers in performing account reviews. In some firms, the
computer runs are reviewed by home office compliance personnel and
in others they are given to the branch office manager to assist him
in his review of customer accounts. Some of these programs have a
particular relevance to options and include:

(1) daily exception runs to identify customer options
transactions in customer accounts not approved for
options trading;

(2) daily exception runs to highlight customer options
transactions which fall outside the types of options
investment strategies for which the customer is
approved ;

(3) monthly or quarterly runs to identify all customer
accounts which generated more than a specified amount
in commissions, or which undertook more than a speci-
fied number of options transactions, or both.

A few firms have begun to use computer programs which correlate
a customer's transaction activity with financial and other data con-
cerninq the suitability of options trading for him, eliminating the
need for cumbersome manual cross referencing of trading with background
information. Several firms employ computer runs which show increases
or decreases in customer equity on a periodic basis and by year-to-date

359

On the whole, however, the Ootions Study found account review pro-
cedures employed by brokeraqe firms to be inadequate to assure a
firm's adherence to suitability reauirements. First, not all firms have
developed automated methods of reviewing customer accounts. Some
firms, even a few with multi-million dollar revenues from their options
business and thousands of customers approved for options trading,
appear to rely heavily on clearly antiquated manual spot-checks, and
other "random" samplings to review customer options activity. For
example, one firm with more than $1.3 million in options revenues
in 1977, and more than 1,200 customers approved for options trading,
informed the Options Study that it conducts only monthly branch office
and ouarterlv home office random manual reviews of customer accounts.
Another firm, with more than $800,000 in options commission revenues
in 1977, and 2,500 customers approved for options trading, appears
to have almost completely abdicated its account review responsibilities,
conduct inn only an annual review of a random manual selection of customer
accounts.

Second, while some firms have developed account review programs
specifically related to options, many still use only account review
procedures developed to detect problems involving stock trading in
customer accounts. Certain of these stock account review procedures
are useful in detecting problems relevant to customer options trading
(e.g. , excessive trading and commission reviews), but, in general,
these programs cannot detect options trading activity which entails

360

larqe or rapid increases in risk to a customer account. Adaptations
of customer credit monitoring systems by some firms have not always
been a dependable means of monitoring customer risk.

lb illustrate this problem, the Options Study identified several
types of options transactions in customer accounts which normally
indicate precipitous increases in customer risk and may signal unsuit-
able tradina strategies, and asked the firms in the industry group
sample whether they had procedures designed to detect such trading.
The activities include: "Leg-Lifting" in spread positions,* converting
covered call positions to uncovered call positions, large scale writing
of uncovered call options, and exercises of long call positions prior
to expiration week. The chart below shows the responses of the firms.

FIPM HAS PROCEDURES

TO DETECT: YES NO

"Lea-Lifting" in spread 46% 54%

oositions

Convert inn covered call 50% 50%

oos it ions to uncovered
call positions

Larqe scale writing of 79% 21%

uncovered call options

Exercises of long call 46% 54%

positions prior to ex-
piration week

* An options "spread" position consists of a "long" side, i.e. , the holder
of the position has purchased an option, and a "short" side, i.e.,
the holder of the position has also sold an option. Each side of the
position is called a "leg". If one side of the position is closed,
as for example, if the holder sells the options in the long "leg",
the leg is said to be "lifted", hence the expression, "leg-lifting."
Once one leg is lifted, the investor is exposed to risks inherent
in other leg.

361

These data suggest that many firms are unable to detect trading
oractices which are of themselves warning signs of unsuitable trans-
actions. The Ootions Study believes that implementation of its recom-
mendations concerning account review Drocedures made in subchapter H,
entitled "Options Trading in Customer Accounts" will help to ensure
that broker aae. firms have such a capability,
c. Keeping suitability records

Rule 17a-4 under the Exchange Act requires that firms maintain all
customer account information during the life of an account (and for
six years after the account is closed). Cne obvious purpose for the
reauirement is to enable firms to assist customers in pursuing investment
programs suitable to their needs. This purpose can be thwarted, however,
if the information is not kept at locations where it actually can be
used. At present, Rule 17a-4 and the equivalent rules of self -regulatory
organizations do not specify that the records be kept at any particular
Dlace. As a conseauence, many firms have not adopted record maintenance
policies which assure that the account information will be kept in
the Dlaces where it is needed .

lerhaps because most self-regulatory organizations inspect the
home office of a firm far more frequently than branch offices, many
firms retain records of customer account statements, background and
financial information only at the home office. Yet, since most invest-
ment recommendations for customers are made at the branch offices, the

362

Options Study believes that the information is also needed there. In
addition, unless branch managers have access to and use such information
in reviewing customer transactions for suitability, such reviews are
of Questionable value.

The Options Study has been told by some in the industry that no
useful Duroose would be served by requiring that background and account
information be retained at the sales office level. If the branch is
small, the argument goes, a manager's personal knowledge of his customers
orovides an adequate basis for assessing suitability; and if the branch
is lane, customer transactions are too voluminous to permit the
manaqer to cross-reference a customer's trading with account,
background and financial information.

These arguments are not persuasive. Regardless of the utility of
the information for supervisory reviews, the information should be
available to registered representatives who make recommendations
and qive advice to customers before orders are entered. In addition,
while there may be instances in which the branch manager's personal
knowledae of his branch's customers obviates the need for recorded in-
formation, the Options Study has reviewed too many cases of unsuitable
tradinq to conclude that a manager's "personal" knowledge serves as an
adeauate basis for conducting suitability reviews. Indeed, these cases
suggest that if the registered representatives knew that the sales-
manager had ready access to suitability information, they might have
refrained from effecting obviously unsuitable trades in customer accounts.

363

As for the arqument that such information, however relevant, is simply
iqnored in larqer offices because of time pressures, the solution for
the firm is not to disregard valuable information, but to develop adequate
and perhaps automated procedures to supervise properly the options business
transacted bv customers of the firm.

Moreover, the need for account, background and financial infor-
mation to be available at broker-dealer sales offices transcends the
value of such information to the firm itself. During a recent special
sales office inspection program conducted by the Commission's staff,
durinq which more than 150 sales offices were inspected, the Commission's
staff repeatedly encountered difficulties in conductinq proper reviews
because customer account and background information was unavailable.
Obviously, the task of Commission and self-regulatory organization
inspectors in adeauately reviewing the suitability of trading in
customer accounts at a branch office would be made far easier — and
would be accomplished more quickly — if customer account information
were available for review at the branch. Accordingly, the Cptions
Studv recommends:

THE SELF-REGULATORY ORGANIZATIONS SHOULD ADOPT
RECORDKEEPING RULES WHICH REQUIRE THAT MEMBER FIRMS
KEEP COPIES OF ACCOUNT STATEMENTS, AND BACKGROUND
AND FINANCIAL INFORMATION FOR CURRENT CUSTOMERS, AND
MAINTAIN THESE RECORDS BOTH IN A READILY ACCESSIBLE
PLACE AT THE SALES OFFICE AT WHICH THE CUSTOMER'S
ACCOUNT IS SERVICED AND IN A READILY ACCESSIBLE
HEADQUARTERS OFFICE LOCATION.

364

5. Suitability - A Final Note

The Oct ions Study believes that the changes recommended in this

section, if adopted, will improve significantly brokerage firms'

controls over the suitability of listed options trading for customers.

Certain of the suitability abuses encountered by the Options Study,

however, indicate far more than inadequacies in the current control

systems of brokerage firms. For instance, the Options Study found the

following suitability cases:

As the result of an automobile accident resulting
in a head injury, one individual developed serious
emotional problems and memory difficulties which
prevented him from holding a job. He had been
fired from more than 20 jobs and his total annual
income consisted of income from the accident com-
pensation award and approximately $5,000 in social
security disability payments. This customer's
reqistered representative invested the customer's
entire assets in an aggressive options trading
program which resulted in losses of more than
$70,000 over a two year period. The registered
representative showed complete disregard for his
customer's limited income, mental incapacity and
dependency upon him and stated in one internal
memorandum that the customer: "has enough assets
to guarantee payment of whatever his little mind
can logically dream up".

Another customer was completely unsophisticated about
financial matters and had no prior experience in the
market other than an investment in a mutual fund. She
had an eighth grade education and her husband a fourth
grade education. At the advice of her registered
reoresentative , she invested her entire $36,000 portfolio
in a margin account trading options. She suffered
substantial losses.

365

A retired coirole with a fixed income of approximately
$12,000 a year had a portfolio of New York Stock
Exchanqe listed stocks which they acauired over a
Deriod of about 25 years, some of which they had
given to their only daughter who was almost completely
disabled. The daughter had an annual income of less
than $5,000 and a net worth of about $45,000. A regis-
tered representative persuaded both the daughter
and her oarents to sell a substantial part of their
stock and to enter into a program of writing calls
covered by warrants, a risky strategy which resulted
in 'significant losses in both accounts.

Cases such as these, and cases of repeated violations, can
occur only where brokerage firms and their employees ignore the obligations
imoosed on them bv the suitability doctrine and act irresponsibly. In
the last example above, when questioned by a self-regulatory organization
about its failure to orevent its registered representative from making
such obviously unsuitable options trades, the brokerage firm responded
that its supervisors had no obligation to know of the specific physical
condition of the customer and that reporting or recording the customer's
known rhvsical disability would be an infringement of the customer's rights.

Another major brokerage firm was sanctioned by the Commission
in 1978 for willful violations of the antifraud provisions of the
Federal securities laws in a case in which customers were permitted
to enqaae in unsuitable options trading and the firm's suitability
screening procedures were found to be ineffective. An inspection of
the firm's options trading activities within six months after the
Commission's enforcement proceeding indicated that as many as

40-940 O - 79 - 26

366

twenty-five percent of the firm's options customers still were trading
options at strategy levels more advanced than those approved by the
firm.

The Oct ions Study believes that the self-regulatory organizations
and the Conmission should take all steps necessary to focus the
attention of brokerage firms on their responsibilities toward their
ootions customers under the suitability doctrine. The rule changes
recommended here should ease this enforcement effort by improving
recordkeeping procedures and by providing critical data in a form usable
to both firms and regulators. Without such an effort, however, violations
will continue, the rule changes recommended will be meaningless, and
salesoersons, like the one in the following recorded conversation,
will continue to put customers, including those who financially do not
belonq in options trading at all, into such clearly unsuitable options
positions as the one transacted below.

EXCERPT FROM A REGISTERED REPRESENTATIVE - CUSTOMER CONVERSATION

SALESMAN: All riqht. Now ... we put a naked [call option position]*
into your account today.
Tried to call you, but I guess you were at school.

* Selling "naked" or uncovered call options is one of the most risky
undertakings in which an options customer can engage. It involves
selling an option entitling the buyer to demand delivery of stock
the seller does not own.

367

CUSTOMER: No, I didn't have any classes. I was trying to get
a credit card.

SALESMAN: ....What kind of credit card were you trying to get?

CUSTOMER: Well it was at [a bank] , trying to talk him into giving
me credit for a ... Master Charge or a Visa. Now they
sent me back a rejection notice, and I'd gotten one
from Bank America said one thing, and [the bank] said
I didn't have enough steady income, so ... I took in
the statement from [your brokerage firm].... He said
he was going to look it over this afternoon and call
me back. It's not a steady income I guess, until you
have two or three years of it.

SALESMAN: It really is a bummer. How much longer of school do you
have left? Or don't you know?

CUSTOMER:

SALESMAN;

CUSTOMER:

I could graduate with a degree in anthropology in June,
if I wanted to, but I'm more or less a professional
student, because I don't see any job at the end of the
line.

Not in anthropology. Okay. One thing you might want
to do, you might want to put my name down, for instance,
as a credit reference if you fill out another form.
Well, it's kind of a standard thing. I did put of course
[your brokerage firm] down ....

368

SALESMAN: Because, see, bankers are funny people, and usually the
quy that's looking at this is some clerk who makes, you
know, four hundred dollars a month, and they gave him
a form in front of him, and it said, unless this answer
is answered this way, and this answer is answered that
way, you reject the guy. You know how it works. So ...
maybe we can talk to the clerk and let him know what's
happening.

* * *

SALESMAN: Okav. Anyway, getting back to the naked [call option
oosition] we put in your account today...

The customer above eventually lost $6,000, a substantial amount
of which was in commissions paid to the brokerage firm and this
©articular salesman.

369

D. DISCLOSURE DOCUMENTS

In many cases, the options customer is the person best motivated
to orotect his own financial interests and to oversee his own options
tradinq. However, unless the customer has sufficient information, in
an understandable form, with which to assess both the risks of options
trad inn and the. status of his account, he cannot adeouately guard his
own interests. The rules of the Commission and the self -regulatory
oraanizations reouire that an options customer be furnished with several
documents intended to inform him, at the time he opens an options account,
of the risks of options trading and, once he has begun trading, of the
status of his account. These documents include a current OCC prospectus,
customer account statements, and written confirmations of each options
transaction in the customer's account. The Options Study has found
that manv customers are unable to understand the prospectus and their
account statements. Not only are these documents frequently too complicated
or too crvotic, thev also aooear to be ineffective as safeguards both
for the customer who is drawn to options by a misleading sales presentation
and aoainst the registered representative who is engaged in improper
activitv.

1 . Account State":

In order to Droperlv oversee his options account, a customer must
first be able to understand his account statement. The Options Study
has found, however, that many customers, and even some supervisors,

370

cannot understand these monthly statements well enough to calculate
easily the status of the account. Sometimes this difficulty results
from the complexity of options trading. At other times, however, lack
of understanding is the result of insufficient disclosure on customer
account statements.

As a result of the inability of many customers to understand their
account statements, registered representatives have been able to mislead
customers about the Drofitability of their options transactions
sometimes for months at a time. These deceptive activities would have
been detected easily by the supervisors of the firm had the customer's
ootions account statement disclosed essential information more fully
and clearlv. In one case, the Options Study found that a registered
representative had directed his firm to send to several of his options
customers monthly withdrawal checks, siphoned from their own existing
eouity reserves but designed to appear to the customer as "profits"
from his options trading program. All the while, each customer's account
eouity was dwindling even further as a result of losses incurred in
the salesman's trading programs, losses which were not disclosed by the
account statements. A monthly account statement which disclosed current
eouity in a customer's account would have prevented, or at least dis-
couraoed, this deceptive practice.

Recent improvements in the account statement form produced by some
firms have proved to be of helo to those firms' customers. For example,

371

one customer, who had been convinced by a registered representative

at a national brokerage firm to engage in exotic options strategies

for five months, described his experience with unintelligible brokerage

firm statements prior to August of 1977:

Before I knew it, I was receiving a large
number of confirmation slips for both opening
and closing spread transactions. I was
thoroughly confused by all the confirmations.
... I was unable to follow the trading nor was
I able to understand the monthly account
statements.

In August of 1977, however, this investor's brokerage firm began

disclosing account equity on customer monthly statements. The same

investor testified about the effect of these disclosures for him:

At the end of July, I agreed to put on some
straddles in order to eliminate my margin
balance. When I received my August 31, 1977
account statement, I discovered that my port-
folio value had decreased from $93,000 to
$67,000. At this time I decided to talk with
[my registered representative] about the con-
dition of my account with the manager of the
office present.

The Options Study encountered other cases where customers similarly
learned of substantial losses in their options accounts only after
their accounts were transferred to brokerage firms which disclosed the
current value of the options account.

Very few firms in the industry group sample provide account
equity information on customer account statements and even fewer
include commission information on such statements. Several firms

372

do have commission information on internal copies of account state-
ment forms, but only one firm sends this information to customers.
No firm in the sample group provides on the account statement the
name of a supervisor whom the customer might call with questions
about his account. The table below sets out the practices of the
industry group sample with regard to other customer account state-
ment disclosures:

ACCOUNT STATEMENT
SHOWS

YES

Commissions attributable
to each transaction during
period

98%

Current price of each security
at end of period

12%

83%

Current value of portfolio
at end of period

91%

Change in portfolio value
during period

100%

All firms in the industry group sample disclose the amount of margin
loans outstanding and interest expenses incurred during the period covered
by the statement, as required by Exchange Act Rule 10b-16.

Exhibit A is an expanded version of a customer's monthly statement,
prepared by a major brokerage firm for one its active options accounts
for the month of May 1978. Registered representatives of the firm
routinely receive this copy of their customers' monthly statements

373

which include all of the followinq items: interest expenses (year-to-
date); aqnreqate commissions (year-to-date); account equity (marked
to market); eouity variation since last statement date; commissions
attributable to each transaction; and the current market value of
each position in the account. The customer, however, is sent a copy
of the statement which includes none of this particular information.
As can be seen from Exhibit A, the registered representative receives
the whole account sheet, while the customer is sent only that
information to the left of the arrow.

For an options customer to be able to oversee his own account he
must receive an account statement which allows him to determine, by
simole inspection, both the current value of his account and any chanqe
in his account value during the period covered by the statement. It
should disclose all costs incurred durinq the period includinq commissions
attributable to each transaction, and, of course, it should show the amount
of any marain loans outstandinq.

Accordinqlv, the Options Study recommends:

THE SELF-REGULATORY ORGANIZATIONS SHOULD ADOPT
RULES REQUIRING THE OPTIONS CUSTOMER'S ACCOUNT
STATEMENT TO SHOW THE EOUITY IN THE CUSTOMER'S
ACCOUNT WITH ALL OPTIONS AND OTHER SECURITIES
POSITIONS MARKED TO MARKET AND THE YEAR TO DATE
PROFIT OR LOSS IN THE ACCOUNT CLEARLY SHOWN.
THE OPTIONS CUSTOMER'S ACCOUNT STATEMENT SHOULD
ALSO SHOW THE AMOUNT OF MARGIN LOANS OUTSTANDING
AS WELL AS COMMISSION CHARGES APPLICABLE TO EACH
TRANSACTION AND OTHER EXPENSES PAID OR PAYABLE,
FOR THE PERIOD COVERED BY THE ACCOUNT STATEMENT
AND YEAR TO DATE.

374

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377

The OCC Prospectus

The Oct ions Clearing Corporation ("OCC") prepares and files a regis-
tration statement under the Securities Act of 1933 (the Securities Act)
as the "issuer" of all listed options traded on the five options exchanges.
This registration statement includes the options prospectus and is filed on
Form S-l , the Commission's general registration fotm, which is used when
no other specialized form has been designated by the Commission's rules.
The most recent options prospectus contains 56 printed pages providing
in considerable detail information about OCC itself and information about
listed options, their risks and the mechanics of options trading. Exchange
rules reouire that this prospectus be delivered to every customer at or
prior to the time his account is approved for listed options trading.
The costs of preparation and distribution of this document have been es-
timated to exceed $1,250,000 annually.

Includinq information about the OCC as an issuer for purposes of the
Securities Act as well as information about options trading and mechanics
has resulted in a lengthy and complicated prospectus which does not meet
the needs of option buyers or sellers who may lack the financial background
to understand the current prospectus.

Unlike other registration statements which are designed to give a
prospective purchaser of a security sufficient information about the
issuer of the securities so that an informed investment decision can
be reached, the options prospectus is designed to provide options buyers
and sellers with adeouate information about options trading and about
the listed options market. Information about the issuer, such as the

378

nature of the issuer's business, its officers and directors, competitors,

and its financial statements, are of little concern to the audience

at whom the OCC prospectus is directed since no purchaser or seller

of listed options is really making an investment in OCC. Counsel for

the OCC has commented that:

The most useful disclosure for investors
does not involve a description of the issuer
and its business, but instead calls for a
description of the economic risks and uses
of options and the mechanics of buying,
writing and exercising options. ... Such
disclosure bears no relationship to OCC's
role as issuer or clearing corporation, but
instead relates to either the basic economic
characteristics of options or to the rules
and Drocedures of the various exchanges
that provide a market for options. /

The American Bar Association has urged that options should be exempted

from the registration provisions of the Securities Act and has offered the

following three reasons in support of their position:

The 1933 Act registration is an inefficient
and unnecessarily costly way of educating
the public regard inq options trading and
disclosing the attendant risks and obliga-
tions. Second, the imposition of the 1933
Act liabilities on parties involved in
issuinq and trading standardized options
is inappropriate and may adversely affect
the quality of public disclosure regarding
options. Third, exempting options from the
registration provisions of the 1933 Act would
clarify the uncertain legal status of the over-
the-counter options market and permit equal
regulation for standardized listed options
and over-the-counter options. /

/ Letter dated November 28, 1978 from Schiff Hardin & Waite, Counsel
to the OCC, to Richard L. Tfeberg, at 2.

/ Letter dated October 24, 1978 from the Subcommittee on Regulation
of Securities Oct ions of the Committee on Regulation of Securities,
Section of Corporation, Banking and Business Law of the American
Bar Association to Richard L. Teberg, at 3-4.

379

Concern by the OCC with Securities Act statutory liabilities,

which normally are imposed upon issuers involved in public offerings

of their own securities, has affected the manner in which OCC has

drafted the options prospectus. Counsel for OCC has noted that:

because of the strict liabilities under the
1933 Act, the OCC prospectus has had to be
drafted in the "defensive" style that is
characteristic of the 1933 Act documents,
tendinq to err on the side of too much dis-
closure, and to include highly technical
descriptions and disclaimers covering
various remote contingencies. /

Procedural requirements under the Securities Act have also resulted

in substantial costs in connection with the OCC prospectus. For

example, Section 10(a)(3) of the Securities Act prohibits the use

of a prospectus more than nine months after the effective date of

the registration statement if the prospectus contains information

which is more than sixteen months old. The American Bar Association

has commented that:

[the requirements of Section 10(a)(3)] when
couoled with the requirements of Form S-l
that call for current financial statements
to be included in a prospectus, has the
effect of reauirinq a new OCC prospectus
to be prepared, filed with the Commission,
and distributed to the public on or before
October 31 of each year , regardless of
whether there have been material changes in
the relevant information contained therein.
Because of the size of the OCC prospectus
(currently 56 pages) and the number of copies

/ Letter dated November 28, 1978 from the OCC, at 2.

380

to be distributed (well over 1,500,000 annually),
the cost- of preparing and distributing a new
prospectus is enormous. In addition, because
of the threat of civil liability under Section
12(1) of the 1933 Act for failure to deliver
a current prospectus (whether or not the changes
from a prospectus previously delivered are
material), brokers and dealers have been required
to establish costly controls to ensure that all
customers receive each new prospectus as it
becomes available. /

The Ootions Study has concluded that information concerning listed
options should be disclosed to investors in a manner readily understandable
to a reader with no financial training and that information about options
and the trad inn markets for options can and should be separated from infor-
mation about the OCC. Absent a statutory amendment, the offer and sale of
anv security, includinq listed options, must continue to conform to the
reauirements of the Securities Act. /

In order to satisfy the requirements of the Securities Act, and in
recoqnition of the unique kind of "offering" represented by the issuance of
listed ootions, the Options Study has the following recommendations.

/ Letter dated October 24, 1978 from the ABA, at 5.

/ The Commission had earlier attempted to reconcile the problem of selling

options with the registration requirements of the Securities Act by pro-
posinq new Rule 238 under the Securities Act to exempt the offer and sale
of certain over-the-counter options from Securities Act registration. A
new Rule 9b-2 under the Exchange Act was also proposed at the same time
which would have imposed disclosure, suitability, and net capital require-
ments on brokers and dealers executing customer transactions in options.
See Securities Act Release No. 5366 (February 8, 1973) and Securities
Exchange Act Release No. 9994 (February 8, 1973). Neither of these
proposed rules was adopted.

381

Compliance by the OCC with the Securities Act can be satisfied
bv the filinq of a special form of registration statement and
orospectus designed for OCC as the issuer of options and adopted
pursuant to the Commission's authority under the Securities Act.
This special form would include information relating to the OCC,
including a description of its business and financial reports.
Under Securities Act Pule 153, the OCC orospectus would be available
to the public upon reouest but could be deemed "delivered" to
each options customer by the OCC when copies of the OCC prospectus
were furnished to the exchanges on which listed options are traded.

Tb rxovide investors with an appropriate disclosure document, a
new document prepared by OCC would be required under the Exchange
Act to be delivered at or prior to the time of an options customer
ooens an account. This document, designed for persons without
financial training, would provide investors with a simple descrip-
tion of the risks and uses of put and call options. This new
document should include a glossary of terms; a description of
(i) the risks of options trading, (ii) the fundamental uses of
options trading, (iii) the terms of options, and (iv) the mechanics
of buying, writing and exercising options; and a simplified discussion
of transaction costs, margin reauirements and tax consequences
of option trading.

This Exchange Act disclosure document could be adopted pursuant
to the Commission's broad authority to regulate options trading under Section

40-940 O - 79 - 27

382

9(b) of the Exchanqe Act. For the reasons cited by the OCC, / the Options
Study believes that this Exchange Act disclosure document should not be
filed as Dart of nor incorporated by reference into a Securities Act
reqistration statement filed by the OCC as the technical "issuer" of all
listed options.

In view of the potential liability for omissions in a Securities
Act Drosoectus, and in recognition of the fact that the Exchange Act
disclosure statement will contain substantial information now included
in the OCC prospectus, it would be desirable for the Commission to find,
pursuant to its authority under Section 7 of the Securities Act, that
certain disclosures concerning options trading which now are included
in the OCC Drospectus are inappropriate under the new Securities Act
reqistration form developed for the OCC.

Alter nativelv, as part of the promulgation of a new Exchange Act
disclosure document and a more limited Securities Act registration state-
ment, the Commission might set forth certain "safe harbor" provisions
which have the effect of relieving OCC and its officers and directors
from liability for omission of certain material from the Securities
Act reqistration statement which would be included in the Exchange
Act disclosure document. This might be patterned after the recently
proposed safe harbor provisions in connection with projections in
statements filed under the federal securities laws.

/ Supra at 3.

383

The effect of these recommendations would be to relieve OCC from
liability under Section 11 of the Securities Act for disclosures
relating to a description and uses of options and the mechanics of
the options trading markets, matters with respect to which OCC has

no special expertise or control. / Regardless of the statutes

under which forms are required or filed , the overriding concern of
the Options Study is that potential options traders be furnished with
a disclosure document designed specifically for their needs and, in
particular, for the needs of those investors with little or no financial
training.

Accordingly, the Options Study recommends:

THE COMMISSION SHOULD ADOPT A SPECIAL REGISTRATION
FORM UNDER THE SECURITIES ACT FOR OCC WHICH WOULD
NOT REQUIRE OCC TO DESCRIBE INFORMATION ABOUT OPTIONS
TRADING AND SHOULD EXERCISE ITS AUTHORITY UNDER THE
EXCHANGE ACT TO REQUIRE THAT A DISCLOSURE DOCUMENT
FILED UNDER THE EXCHANGE ACT DESCRIBING OPTIONS, THEIR
RISKS AND THE MECHANICS OF OPTIONS TRADING BE PREPARED
BY OCC AND BE DELIVERED BY BROKER-DEALERS TO EACH OPTIONS
CUSTOMER AT OR PRIOR TO THE TIME THE CUSTOMER OPENS AN
OPTIONS ACCOUNT.

/ Neither alternative, however, would effect the present status of
conventional options under the Securities Act, namely, that their
offer and sale must oe effected in compliance with Section 5.

384

E. PROMOTING OPTIONS - GENERAL PROBLEMS

1. Introduction

In order to establish and maintain an options business, that is, to
sell and promote options, a brokerage firm needs to communicate with
actual or Dotential customers. Communication is necessary first to
attract the customers to the firm — a practice known in the industry
as "prospectinq" — and then to keep customers interested in options
and in doing business with the firm.

Firms must also communicate with customers for reasons other than to
nromote business. Before options trading may be considered suitable for
a customer, the customer should understand the risks involved in such
tradinq. Since the customer must rely, in large part, on the brokerage
firm and its representatives to explain those risks, communications from a
brokerage firm may have an educational as well as a promotional purpose. In
fact, information supplied to customers by firms generally serves these dual
and often competing needs. Finally, a firm must communicate with actual
customers to keep them informed of the status of their accounts and of
transactions done in their accounts.

At each stage in the communication process, brokerage firms and their
reqistered representatives use a variety of materials and methods to reach
customers. Some firms use mass media advertising extensively. Some firms
give freouent "seminars". Most firms allow their registered representatives
to solicit new business or generate more business through telephone calls.

385

Promotional materials may also be mailed to "prospects" and existing custo-
mers, or may be available at seminars or in brokerage firm offices as
"handouts."

The Ctotions Study has reviewed the various types of solicitation and
informational materials used by firms to acquire and inform options
customers. These materials include advertisements and sales literature,
seminar scripts, promotional letters, worksheets and performance reports.
The Ootions Study has also studied a particular sales technique which
seems to be unusually effective in enlisting options customers — the
"options proqram."

Althouqh each of these types of materials and solicitation techniques
have special problems which will be discussed in following sections, one
recurring shortcoming of virtually all types of sales promotional efforts
is the underlying message used to attract options customers. The promotional
messaae, conveyed explicitly to the customer by both the brokerage
firms and the individual registered representatives, is that predict-
able and verv attractive returns on investment are available, with
a minimum of risk, to persons who use options in their investment
orograms. Vhile this message serves as the most effective means
of persuading customers to consider options as an investment, it
is frequently misleading.

386

2. Rates of Return on Investment

A rate of return expresses the relationship between the amount
a customer invests and the amount he earns from that investment. For
example, if $100 is earned from a $lf000 investment in a period of one
year , the rate of return is 10 percent per year . Rates of return can
be used either to measure the past profitability of an investment, as
in a performance report, or to project the profit potential of an
investment, as in a worksheet.

When properly used, rates of return may be informative to an
investor, but the Options Study believes that options investors
qenerally are misled by the use of rates of return. First, firms
and reqistered representatives tend to overemphasize attractive
ootential rates of return from options investments while de-emphasizing
the risks of options investments. Second, rates of return are often
expressed on an annualized basis without any clear discussion or
disclosure of the many assumptions which must be made to express the
return on an options investment in annualized terms. lb compound the
Droblem of the use of rates of return, firms and salespersons sometimes
qive customers the impression that an attractive percentage return on
a recommended options investment or series of investments can be predicted
with certainty, thus leading customers to believe that a profit is promised
or guaranteed.

387

a. Exaggerated rates of return

The Options Study has found that attractive rates of return are

used in virtually all types of promotional efforts designed to increase

investor interest in options, and are used also in materials designed to

"educate" customers about options. Typical are the following conclusions

in a national broker aqe firm's option writing guide:

Hdw much income? Hdw much downside protection?
No assurances can be given. But we believe — based
on what has haopened over the years — that an option
writing program can be expected to produce a yield
of about 15% a year on vour capital. That's in stable
or rising markets. In falling markets, an option
writer can possibly acouire protection against a
decline of about 15% a year in equity capital.

That isn't yield of course, as in the case of stable
or rising markets, but protection. In either case, this
oercentage figure represents hard cash premiums received
at the time of writing an option. Cash that can add to
caoital or replace capital eroded by declines in stock
prices.

On the basis of these statements, several registered representa-
tives have assumed that rates of 15 percent and higher are reasonable
returns for options programs and have led customers to expect these
kinds of return. Some financial writers have used this national
brokerage firm's claim to support their assertions that even greater
rates of return are possible from listed options trading. A regional
options coordinator in one firm used this statement as the basis
for suggesting to registered representatives that they use sales
presentations which spoke of an "expected 15% to 20% return."

388

The options exchanges also have contributed to the overstating
of rates of return. For instance, the CBOE has distributed as part
of its promotional materials a reprint of an interview in which
one of its governors told readers of a widely circulated financial
publication:

[A]s a conservative investor, I can write

[sell] ootions to increase my total return
from that portfolio of stocks in companies I
believe in. People talk about option spreading
programs and mention 15%, 20% a year if they're
lucky. That's peanuts to what a conservative
investor can earn by holding stocks and writing
options on them.

Some salespersons have used this interview routinely in order to solicit

new options customers.

The results of options trading, however, often are very different from

the returns the customer has been led to expect. For example:

. Che investment advisor - registered representative team

premised an investor who spoke little English a 1000 percent
return on her $2,000 investment in options over a period of
several months. The investor lost her entire investment.

Another registered representative told several customers
about the 70 percent return he could consistently achieve for
clients throuqh an uncovered call writing program. All of
these investors suffered substantial losses as the result of
this options trading program.

Two investors claimed that their registered representatives
predicted that they would "double" their money in a short
period of time. Both lost substantial parts of their investment,

389

. One registered representative promised same prospective
clients between 10 and 500 percent return on options
investments and other prospective customers "fantastic"
returns with "minimal risk". After fifteen months
of trading, his thirteen most active customer accounts
had all experienced losses, ranging from 13 to 74
oercent of the money invested .

b. Annualized rates of return

When a return on an amount invested for either less or more than
a year is expressed in terms of a yearly rate, it is said to be "annualized.1
For example, an investment which results in a 5 percent return in four
months is said to yield 15 percent on an annualized basis. The expression
"annualized basis" here means that if the same money were invested at the
same rate of return for the whole year, the return would equal 15 percent
of the money invested.

HDwever , since the life of any listed option is nine months or
less, one cannot assume that funds invested in listed options can be
reinvested at the same rate of return three, six, or nine months later.
Interest rates, transaction costs and, of course, premium levels are
all subject to change. Therefore, any annualized rate of return relating
to options is misleading if the basis for the extrapolation is not disclosed,

Tb take an extreme hypothetical example, the purchase of an
out-of-the-money call option for 50 cents at the beginning of a month
and the sale of the option for $1.00 at the end of the month could yield
a 100 oercent return on investment (disregarding all transaction costs) .

390

However, to tell the investor that this transaction would yield 1,200
oercent on an annualized basis could be very misleading unless the
customer were also told of the impact of transaction costs and of the
virtual imrossibility that this trade could be executed twelve consecutive
times in a similarly profitable manner.

Fbr these reasons, some professionals in the industry view the
practice of expressing options investments in annualized terms as
inherently fraudulent or, at best, meaningless. Other professionals
arque that annualized rates of return are the only way that an investor
can easily measure and compare the profitability of an options investment
to another investment opportunity. For instance, the yield on bank
savings accounts, treasury bills and other debt instruments is usually
exoressed in annualized terms. Some options professionals believe
that the competitive pressure from these other investment opportunities
mandates the use of annualized returns to describe options transactions
or strateqies. Che options salesman stated the competitive realities
succinctly: "...to get the business, you have to say something
[reqardinq rates of return] ."

Whatever the merits of annual ization, the use of annualized
returns to describe the profitability of proposed options transactions,
without disclosure of all underlying assumptions, is misleading to
investors. Che brokerage firm recently attempted to deal with the
problem of such disclosure by disseminating to its branch managers

391

a memorandum which suqqested that the following admonition be given

to customers whenever annualized rates were mentioned:

Use of annualized rates of return makes it easier
to compare different strategies involving different
durations. It does not imply, however, that the investor
will realize the described rate over a period as great as
one year or that transactions entered into after the
suagested investment position is liquidated would
produce comDarable rates of return.

This same firm has also included on its options worksheet a disclaimer

concerninq the likelihood that a specific trade would achieve the

annualized rate set out on the worksheet.

Not all disclaimers, however, adeauately inform customers of the

assumptions implicit in annual izat ion. In fact, some serve to further

mislead investors by disclaiming unrealistic assumptions:

Our mathematical models suggest positions that should
normallv appreciate between 10% and 25% annually. These
rates cannot, of course, be guaranteed. However, unless
the particular corporation appears to be going bankrupt
or a national catastrophe occurs, there is normally a very
small risk.

c. Other problems with the use of rates of return

In addition to being exaggerated and misleading, annualized rate

of return fiqures, when used in promotional materials for options, are

troublesome for other reasons.

( 1) Misleading calculations

Since the rate of return figure is freauently the major device

used to gain the interest of customers in various types of promotional

392

materials, the computation which establishes the return figure should

be done correctly. Ffowever , the Options Study has reviewed several

promotional documents where the figures simply were wrong. Even the

CBOE reference manual, described by the CBOE as a "valuable tool

for the registered representative as he endeavors to present the option

concept to the investment public", contains a prominent rate of return

computation which is incorrect.

The CBOE attempted to show why an investor contemplating a

$5,000 stock investment should consider a combined investment in both

options and short-term money market instruments, where $500 would be

committed to options and the remaining $4,500 to the short-term money

market paper. Ihe error resulted because the investor's return on the

entire $5,000 investment was expressed instead as a percentage of the

$500 committed to options. The CBOE's example is as follows:

[A]n AT 50 call option might have been purchased
six months prior to expiration, when the stock was at
50 and the option was selling for 5. At the same time,
the remaining funds [$4,475] might have been invested
in a short-term money market investment yielding 5%.
If, at expiration, [six months later] the stock had
appreciated in value to 60, the option might be sell-
ing at its intrinsic value of 10.

Cost:

Proceeds:

393

$ 500 Option premium

+ 25 Commission

$ 525 Total cost

$1,000 Sale of option

- 40 Commission

$ 96i0" Total option proceeds

+ 112 5% on $4,475 invested
$1,072 Total proceeds

$1,072 Proceeds

- 525 Cost

$ 54~7 Net orofit (104% on the original investment)

In reality, the "net profit" of $547 represents not 104 percent, but
less than 11 percent of the total original investment of $5,000.

(2) Failure to include transaction costs

The accuracy of any rate of return figure is significantly affected
by brokerage commissions, interest charges, and other transaction costs.
Yet, since emission of these figures simplifies the computations, promo-
tional literature, even that produced by one of the options exchanges,
does not always include transaction costs when calculating rates of
return. Tb ignore these costs, however, can result in rate of return
computations misleading to the public investor.

(3) Distorted presentations

Another practice in the industry is to portray rates of return
in percentage figures (which generally are more impressive than dol-
lar fiqures) for gains, but almost never to portray losses in percen-
tage fiqures. Potential losses are discussed, if at all, in absolute

394

dollar figures. To give a hypothetical example, if an investor bought

an option for 50 cents, and sold the option for $1.00, most promotional

literature would call his result a 100 percent return. However, if

the investor lost the 50 cents, that is, if the option became worthless,

the literature would not say that the investor had lost 100 percent

of his investment. Instead, the investor would be said to have suffered

a loss of "only 50 cents" or a loss "limited to 50 cents."

The "strategies" chapter of the AMEX's 1977 "A Guide to Listed
Ctotions" exemplifies the practice of expressing gains as percentages
but losses in dollar figures. Eighteen times in that chapter a
computation of gains is offered. In ten of those instances, gains
are expressed in percentage terms; in eiaht of those instances
gains are expressed in absolute dollar terms only. On the other
hand, while the possibility of loss is mentioned thirty times
in the same chapter , only once are losses expressed as a percentage
of investment, with losses expressed in absolute dollar terms twenty-
nine times.

3. Predictions, Promises and Guarantees

a. Predictions without a reasonable basis

The use of exaggerated rate of return figures to promote and sell
options is often accompanied by actual or subtle suggestions that the
designated return is a predictable result of a proposed options investment,

395

The Commission has long held that a registered representative must
have a reasonable basis for any recommendation he makes or opinion he
expresses about a security since "groundless opinions came within the
ambit of false and misleading statements prohibited by the securities
laws." 31/ Predictions of earnings for speculative securities have been
considered inherently misleading unless accompanied by "full disclosure
of both the facts upon which they are based and the attendant uncertain-
ties." 32/

The Options Studv has encountered numerous instances in which a
registered representative's opinion as to the anticipated rate of return
for an options transaction or strategy, although expressed with the
authority and conviction of a prediction, had no reasonable basis. When
asked to justify their opinions, registered representatives sometimes
admit that they have no basis for the opinion or else respond with only
vaque generalities. One registered representative indicated that her
"objective" of achieving a "20-30% consistent annual return" for customers
in options tradina was based upon her knowledge of a seven-year market
cycle. Ftowever , she could not explain how to relate this cycle to the
listed options markets which has existed only since 1973. Mother registered

31/ Alexander Reid & Co., 40 SEC 986 (1962).

32/ Richard J. Buck & Co., 43 SEC 998, 1006 (1968), aff 'd sub nom.
Hanley v. SEC, 415 F.2d 589 (2d Cir . 1969).

396

representative told his customers that they could expect between 15 and
20 percent annualized returns with minimal risks. Although he based this
prediction upon his "general feeling for the performance of accounts"
he had seen, he could not specifically identify for Commission investigators
any account in which such returns had been achieved. Cne registered
representative testified that he felt his representation to customers
of a 25 oercent return in options was "conservative" based upon statements
by the firm's options coordinator that certain accounts in the firm had
returned as high as 40 percent. Another registered representative solicited
options customers with representations of returns as high as 15 percent,
although he admitted that he had never seen an options account return
that much.

One registered representative testified that he solicited potential
options customers by presenting a 25 percent yearly rate of return as a
tarqet which he hoped to achieve through options. Several of his customers
claimed that he had premised them even larger annual returns, in some
cases ranging up to 500 percent. The Commission's staff analyzed this
registered representative's customer options accounts for the period
covering the bulk of his options trading activity and found that only
three of 40 accounts were profitable, that customer losses aggregated
$292,000, and that the average account lost 24 percent of the equity
invested, with commissions comprising 67 percent of those losses.

397

Similarly, by using pseudo-scientific articles and a newsletter,

one broker-advisor team qave potential customers the impression that it

could scientifically predict results for customers participating in the

team's options trading program. The team claimed that no account managed

bv the advisor had ever lost money. In addition, a published article

authored bv the advisor , which claimed that accounts under management had

averaqed more than a 10 percent return annually over the past several

years, was reDrinted and distributed to potential clients. When asked

for the basis of the 10 percent figure used in this article, the advisor

could onlv respond:

It is common and accepted practice in this [academic]
society and others to publish figures and not too extensive
computations relating to those figures.

Later , the advisor admitted having no records to substantiate his claims
concerning the profitability of clients' options accounts except for
records of one calendar quarter during which 21 of the 49 managed accounts
actually had experienced a decrease in net asset value.

Another team of salesmen told their customers that they were able
to predict the profitability of proposed options transactions by means
of a "scientific system" which they compared to short-term weather fore-
casting. Their profitability forecasts, however, were cloudy and invariably
wrong .

40-940 O - 79 - 28

398

b. Objective versus guarantee

The emphasis in many of the materials used to promote and sell op-
tions is on achieving an attractive rate of return with a minimum of risk.
Given these optimistic promotional efforts, statements made to customers
bv their registered representatives about the profitability of options
often mislead investors into believing a risk-free return is predicted,
promised, or even guaranteed.

Some investors claim to have been told that they would "almost
definitely" receive a favorable rate of return from options trading;
others claim that specific returns have been guaranteed outright.
Even when representations are phrased as "objectives" , "goals" or
reasonable targets for profitability, investors often believe that
they have been promised a particular rate of return. Investors
typically are told that options have a profit potential of 12 percent
to 14 percent; that an options program can produce "a 20-30% consistent
annual return"; that options trading is "expected to produce" a given
rate of return; or that certain options trading strategies or programs
are "lucrative". In one instance, an investor was told that options
trading is the same as having "someone throwing quarters at you."

When representations of this type are coupled with statements
which minimize the risk of loss, the investor can understandably
believe that he is being promised a favorable rate of return.

399

Some reqistered representatives have told customers that options
were a "guaranteed way to make qood" and that the customer "couldn't
lose." One reqistered representative claimed he had a "foolproof
formula", complete with eouations, which demonstrated how a customer
could make "large profits of 35 percent without possibility of
loss."

Althouqh reqistered representatives usually deny promising any
customer a profit, the Options Study has identified several situations
in which options customers have been given outright guarantees. For
instance, one registered representative guaranteed to his customer,
in writing, that the customer's losses would not exceed $2,000 from
trading options in three months. He renewed this guarantee each
three months for a nine month period. The registered representative
signed his guarantee on behalf of the brokerage firm, telling
his customer that the firm would honor the written guarantee.
The customer incurred substantial losses and the guarantee proved
worthless. The same registered representative offered a comparable
guarantee to another of his customers. Similarly, another registered
representative Drovided a customer with a written guarantee which assured
the customer a 50 percent return in only four months. In still another
instance, a registered representative deposited funds in a customer's
account as part of an arrangement with the customer to guarantee the
customer against loss. On occasion, the Commission's examiners have

400

also found indications that certain registered representatives selling
options were guaranteeing customers against unprofitable transactions
by regularly transferring such transactions from customer accounts to
the firm's error account. Guaranteeing customer transactions against
loss is expressly prohibited by exchange rules. 33/

4. Controls

The following table sets out firm policies of the industry group
sample concerning price predictions, predictions of return on investment
and guarantees:

YES NO NO ANSWER

Firm has a policy applicable 73% 25% 2%

to options prohibiting sales
persons making price predictions
to customers

Finn has a policy applicable 62% 38% —

to options prohibiting sales

persons making predictions

of return on investment to

customers

Firm has a policy applicable 98% 2% —

to options prohibiting sales

persons making guarantees of

return on investment to

customers

33/ E\g_. , Rule 9.18, CBOE GUIDE (CCH) II 2318.

401

To monitor these policies, most firms review correspondence and
customer complaints and rely on the integrity and professionalism of
their sales force. Such controls have not been effective in preventing
abuse or in protecting investors.

Of the firms in the industry group sample, 52 percent allow
salespersons to use annualized rates of return when discussing the
profitability of options transactions with options customers. Although
manv of these firms discourage or limit the use of annualized returns
in some manner, most have no effective means for monitoring compliance
with their restrictions. 34/

The Options Study recommends :

THE SELF-REGULATORY ORGANIZATIONS SHOULD AMEND THEIR
OPTIONS RULES TO REQUIRE (1) THAT WHENEVER RATES OF RETURN
ARE CALCULATED FOR DISCLOSURE TO INVESTORS, ALL RELEVANT
COSTS MUST BE INCLUDED IN THE COMPUTATION; AND (2)
THAT WHENEVER ANNUALIZED RETURNS ARE USED TO EXPRESS THE
PROFITABILITY OF AN OPTIONS TRANSACTION, ALL MATERIAL
ASSUMPTIONS IN THE PROCESS OF ANNUALIZING MUST BE DISCLOSED
TO THE INVESTOR AND A WRITTEN RECORD OF ANY RATE QUOTED
TO A CUSTOMER MUST BE KEPT.

34/ The self -regulatory organizations also have regulations which
attempt to circumscribe the use of rates of return by brokerage
firms in advertising and sales literature. The industry's recently
promulgated uniform guidelines for advertising and sales literature
are a beginning in the regulatory effort to control some of the
problems arising from the use of annualized rates of return to
describe the profitability of options transactions. These guidelines
generally provide that annualized rates of return, when used, must
be accompanied by a description of their means of calculation as
well as the assumptions underlying the annual ization process.

402

F. PROMOTING OPTIONS - SPECIFIC METHODS.

1. Advertisements and Sales Literature

Advertisements and sales literature generally represent a brokerage
firm's most formal and "official" efforts at promoting and informing
customers about options. Unlike worksheets, performance reports and other
ad hoc promotional efforts of individual branch offices or salespersons,
advertisements and sales literature are usually produced by the firm's
headquarters office and bear the official stamp of approval from management.

The Options Study's review of a sampling of advertisements and sales
literature revealed that promotional styles differ among firms, and even
within the same firm from time to time, and that these styles vary from
low-key to aggressive. The materials seen by the Options Study primarily
were those filed with the self-regulatory organizations for review or
approval. Although many of these materials seemed unobjectionable, cer-
tain problems were identified. These problems continue to be of concern
since some salespersons and firms sometimes neglect to file advertising
materials for review as required by exchange rules. 35/
a. Promises of attractive returns

As noted earlier, the holding out of attractive returns on investment
is a recurring theme in promotional programs of brokerage firms. As also

35/ E.g., Rule 9.21, CBOE GUIDE (CCH) 11 2321; Rule 483, 2 ASE GUIDE
(CCH) 11 9494. See Chapter VI.

403

noted, customers often believe that they have been "promised" these

attractive returns if they decide to invest in options. The Options Study

has found that promises of successful results are implicit in many of

the advertisina and sales literature documents it reviewed. These "promises"

are particularly significant because they are conveyed to a customer,

not by salesoersons, but through materials issued by the firm itself.

If these materials make exaggerated or unrealistic claims about options,

these claims will not only mislead the public directly, but they also

will indicate to the firm's sales force that the firm approves of similarly

exaoqerated claims in oresentations made by registered representatives

in direct contact with customers.

The following are a few examples from advertisements or sales literature

reviewed by the Ootions Study which seem to make or imply promises that

favorable results will usually flow from options trading:

. "Would you be interested in receiving 15 to 20% annual income
from the stocks you now own?" March 1976. [The CBGE changed
"receiving 15-20%" to "up to 15-20%". A year later, on recon-
sideration, the CBOE required the firm to delete the reference
to specific numbers and to simply use the language "an attractive
return."]

. "Don't expect to triple your money using options . . .15%

is our goal." April 1976. [Large bold-print advertisement,

withdrawn after several months use when the CBOE retracted its
approval . ]

. "Tempted? Come on in. Everybody loves a 10%-12% yield."
September, 1977. [Promotional Letter.]

404

"... why settle for 9%, if there is the opportunity to achieve
siqnificantly more with limited risk?" [Promotional letter
to "qualified clients and prospects," to be accompanied by
an OCC Prospectus.] February, 1978.

"If your firm has a qualified pension plan of any type, for
the benefit of you or your employees, I would like the oppor-
tunity to outline an investment concept that is an alternative
to fixed income securities with a substantially qreater percent
return. Tne main features of this investment are:

- Short term market exposure, less than 9 months.

- Liquid it v

- Returns of 10-16% on net investment...."
[Promotional letter.] March, 1977.

Many of these advertisements emphasize the possible rewards of options
tradinq without adequately discussing the corresponding risks, in clear
contravention of exchange rules which require a balanced presentation. 36/
b. Touting the "Expert"

Another promotional theme found in advertisements and sales liter-
ature which is somewhat related to the problem of promises and predictions,
is the touting of the firm's in-house options "expert" or expertise. A
number of firms also claim to have a special formula or computer program
desiqned to help the options "expert" achieve favorable results for options
customers. For example, one firm has an "Oasis-5 stock sensitivity program"
another has the "Peroni system". Another firm attempted to promote one
of its employees as a "well-known options advisor to CBOE, AMEX, member
of the Board of Directors of the Options Clearing Corporation....", but

36/ E.g., Rule 9. 21. 01. II. A, CBOE GUIDE (CCH) f 2321.

405

was forced to modify the language on the insistence of the options exchanges.
And one firm claims to have "one of the most sophisticated options programs
in the country."

These claims are easily made because, in general, brokerage firms
have not been required to document the success of their programs or formulas,
or to demonstrate the exDertise of their "expert". Even the ROP examination
is not desiqned to do more than test for a minimum basic understanding
of the mechanics of listed options.

Since a common complaint of options customers is that they did not
understand options, and were induced to invest in options only after receiving
assurances that they could rely on the proclaimed expertise and special
capabilities of a brokerage firm and its options experts, the Options
Study is particularly concerned about management-sanctioned advertisements
which create an impression that an options "expert" or options expertise
is indeed available at the firm.

Therefore, the Options Study recommends:

THE RULES OF THE SELF-REGULATORY ORGANIZATIONS
SHOULD BE AMENDED TO REQUIRE THAT MEMBER FIRMS
MAKE AVAILABLE FOR PUBLIC INSPECTION UNEQUIVOCAL
AND COMPREHENSIVE EVIDENCE TO SUPPORT ANY CLAIMS
MADE ON BEHALF OF OPTIONS "PROGRAMS" OR THE OPTIONS
"EXPERTISE" OF SALESPERSONS.

c. Flamboyant language

The complexity of options as an investment vehicle makes them an

inappropriate subject for aggressive or "hard sell" techniques. Yet,

406

the Options Study found a disturbing number of options advertisements of

Questionable taste and veracity. While issues of tone and taste may be

matters of individual preference, the rules of the options exchanges plainly

prohibit use of promotional materials which are misleading or which

fail "to meet general standards of good taste and judgment common

to the securities industry." 37/ The following are a few examples

of promotional statements which seem to have both qualities:

. "Do you want more mileage from your commission dollars?"
March 1976.

"Would you like to buy stock at an effective price below current
market using Options?" March 1976.

"learn how you may buy stocks below the current market price
- and also be paid a premium." October 1977. [The CBOE changed
"how you may buy" to "how it is possible to buy" and struck out
references to a premium. ]

. "How to make money by buying and selling options on the same
stock at the same price." October 1977. [The CBOE changed
"How to" to "learn how you might...."]

There is a magical tone to these statements. In fact, the last

example above continued: "No we're not pulling your leg." Another firm's

oroposed advertisement began "Believe it or not..." If materials produced

by the broker aqe firm foster the impression that options work in mysterious

but marvelous ways, the customer is left either without information, or

worse, with misinformation about options.

37/ See, e.g., Rule 9.21(b)( iii) , CBOE GUIDE (CCH) 1| 2321. Tne other
options exchanges have similar rules.

407

2. Seminars

Seminars are a popular technique for attracting and educating options
customers. Firms use various labels to describe seminars — e.g. "clinic"
or "forum" — and same seminars are purportedly designed to reach only
" sophisticated" or "experienced" options investors. A few firms
occasionally go so far as to charge a fee for a seminar , which is sometimes
then labeled a "course."

In most cases, brokerage firms do not provide the texts of options
seminars to the options exchanges in advance, since advance review of
materials is required only for mass media materials. However, mass media
advertisements for options seminars must be cleared by the exchanges,
and the content of the seminars must conform to general exchange rules
which reouire truthfulness and good taste in communications with the
oubl ic .

Because seminars are advertised as primarily educational — and not
Dromotional — meetings, they evoke an image of a balanced presentation
of the advantages and disadvantages of using options in investment programs.
The texts of the few seminars that have been reviewed by the Options Study,
however , reveal that seminars can be far from the balanced presentations
they often purport to be , and rather , may be simply another means used
by a firm for attracting options customers. As such, they contain the
same promotional bias that characterizes other forms of advertising.

408

The presentation of one national broker-dealer firm's series of
seminars, featuring the "[Name] System" of options investment, exemplifies
this problem. This "system" — described as a "high yield; low risk
investment concept" — was essentially a covered options writing program
to which the " [Name] System" was supposed to provide "added protection
and profit potential". Audiences were told that the system featured:

. "Risk reduction"

. "Earning the time premium"

. "Management of the portfolio"

. "Net yield of 18-20 percent"
The audience was further informed that a properly managed covered
writing program would increase the odds of investment success by 3 to
1 over the investor who remained a "non-writer". These odds were derived
from a "computer analysis" of stock market performance over a twelve
year period."

To reinforce the audience's belief in the success of the "system",
an example of a profitable covered writing investment was described,
complete with attractive annualized rates of return on investment.
The audience was told that, by carefully choosing the stock and monitoring
the stock-option position, a writer could enjoy attractive gains in either
an uo or down market. All examples seem to have been selected carefully to
ensure a favorable and predictable result.

409

The " [Name] System" seminars were conducted from mid-1976 until

February 1978, when the text of the presentation finally came to the

attention of the CBOE. The CBOE promptly objected to the contents,

finding that the presentation was "unbalanced in terms of risk and

ootential reward," and that it:

. fail[ed] to address the subject of suitability;

. frequently quo t[ed] ... rather inflated
theoretically attainable annualized rates
of return, [without making any] attempt
to explain how the figures were derived;

. contain [ed] implied guarantees and other
oromissory language.

The broker-dealer firm was thus forced to revise the text of the
seminar two years after the seminar was first presented to the public.
The revisions were not finally approved by the CBOE until April 1978.

Another firm's seminar script reviewed by the Options Study
suggested that the "harsh choice" facing an investor who confronted
the "bad news" of inflation (depicted as a large fierce monster devouring
money) was to "either cut back on living standards or look for new
ways to boost [his] investment yield past that 8.2% inflation line."
The "good news" was the availability of a "little-known way to possibly
out-race inflation without taking on a lot of risk ..." And the way
was: "option writing for more income now." (Emphasis in original.)

410

The presentation used evocative words designed to promote options.
Tne hypothetical stock chosen for purchase in the covered writing example
was called "Superior Company" , and the investor "who didn't believe in
options" was named "Mr. Lackluster". (Tne AMEX insisted that the name
be changed to "Mr. Jones".) The first covered writing example provided
the investor with a 14 percent annualized return and subsequent hypothetical
examples showed the options writer almost always faring better than
the mere stock purchaser. Tne one exception occurred when Superior's
stock "sho[t] up" beyond the strike price. In that case, "the buyer
would [have] exercise [d] his option and [the covered writer] would [have]
miss[ed] out on all the gain above the striking price ...." However,
the covered writer "would come out ahead in the three out of four situations
we've been seeing most often in the market."

Brokeraqe firms unquestionably have the right to promote the sale of
securities — including options — through various promotional devices,
including seminars. However, firms should not be permitted to engage in
sales promotions under the guise of offering an educational service.

Accordingly, the Options Study recommends:

(1) THE RULES OF THE SELF -REGULATORY ORGANIZATIONS
SHOULD BE AMENDED TO REQUIRE THAT WHEN MEMBER
FIFMS USE SEMINARS TO PROMOTE OPTIONS, THEY
MAKE THE FOLLOWING DISCLOSURES TO THOSE ATTENDING:

411

—IF THE "LECTURER" IN THE SEMINAR IS A

BROKERAGE FIRM EMPLOYEE COMPENSATED IN WHOLE
OR PARI' BY COMMISSIONS, AND IS USING THE SEMINAR
TECHNIQUE TO ATTRACT CUSTOMERS, HIS FINANCIAL
INTEREST IN THE ACOUISTION OF CUSTOMERS FROM
THE AUDIENCE SHOULD BE DISCLOSED;

—IF A "PROGRAM" OR "SYSTEM" DESCRIBED IN THE
SEMINAR IS ALREADY IN USE, THE CUMULATIVE
EXPEKIENCE OF THE PROGRAM'S PARiTCIPANTS SHOULD
Lit: FULLY DISCLOSED AND DOCUMENTED, AND
THE AUDIENCE SHOULD tfE WARNED THAT PAST
RESULTS ARE NO MEASURE OF FUTURE PERFORMANCE ;

—IF THE PROGRAM IS TOO NEW TO HAVE A PERFORMANCE
HISTORY, THE AUDIENCE SHOULD BE FULLY APPRISED
OF THE UNTRIED NATURE OF THE PROGRAM.

(2) SELF-REGULATORY ORGANIZATIONS SHOULD DEVELOP A PROGRAM
IN WHICH SURPRISE ATTENDANCE AT SEMINARS FORMS PARI OF
'THEIR OVERALL INSPECTION PROGRAM RELATING TO OPTIONS
SAUjS PRACTICES.

3. worxsneets and Performance Reports

WorJcsneets portray the profit potential of proposed options trans-
actions and are wiaeiy used throughout the securities industry to depict
trie potential risJcs and returns of proposed transactions to customers.
Tney are used Doth in face- to- face sales presentations between customers
and registered representatives and are sometimes sent to customers to
solicit tneir participation in particular options transactions.

worksheets can oe adapted to portray the risk and return possibilities
or nost types of options transactions, but the Options Study found them
used most frequently in conjunction with recommendations concerning

412

covered call writing strategies. A typical worksheet for a covered call

writing transaction would show the maximum potential returns available

to an investor if the underlying stock were called away from the investor

(that is, if the holder of the option exercised the option), and if the

stock were not called away (that is, if the option were not exercised).

Some covered writing worksheets also include a calculation of a "break-even

point" for the proposed transaction.

Some firms prohibit the use of worksheets, while other firms limit

their use. The following table sets out the policies of firms in the

industry group sample with regard to showing or sending worksheets to

customers.

Existing Ebtential

Customers Customers

Pegistered repre-
sentatives may show 72% 63%
worksheets to:

Registered repre-
sentatives may send 61% 53%
worksheets to:

As distinguished from worksheets, which present for options customers
the profit of potential transactions, "performance reports" purport to
analyze the results of actual options transactions. Two types of options
performance reports are commonly used in the brokerage industry: (1) a
report of realized or unrealized gain or loss in a customer's account
resulting from a single options transaction or series of options trans-
actions; and (2) a report containing a similar analysis over a specific

413

time period of the customer's entire portfolio or of his options
Dortfolio alone. The typical options performance report is generally
a statement of profit and loss. It may serve to supplement, and if
properly done, help translate, the periodic customer account statements
which are often difficult to understand.

In addition to serving as supplements to the periodic account
statements, performance reports may be used as selling documents,
and shown to potential customers to solicit new options business.
The successful experience of actual customers can be an extremely
effective inducement to potential customers considering options
as an investment.

The table below sets out the policies of firms in the industry
qroup sample with reqard to use of performance reports:

Cwner of
Account

Prospective
Customers

Allow computer generated
reports to be shown to:

Allow reports other than
computer aenerated to be
shown to:

28%

54%

Thirty-eiqht percent of the industry group sample prohibits the
use of performance reports by registered representatives altogether

40-940 O - 79 - 29

414

Both worksheets and performance reports are generally prepared
by individual registered representatives, although, in the case
of worksheets, the brokerage firm may supply the format on which the
registered representative fills in numbers to illustrate a transaction.
If used correctly, both performance reports and worksheets can furnish
useful information to existing or potential customers. However, the
Options Study has found that as with other promotional materials,
worksheets and performance reports too often are used in a manner
unfair to investors.

a. Exaggerated returns

Unreal istically high rates of return are often depicted in worksheets.

It is not uncommon to see worksheets indicating available returns of up

to 30 percent. Che registered representative used for sales presentations,

and later sent to one of his customers, a worksheet which quoted returns

of between 43.1 percent and 73.2 percent. This same worksheet stated:

IF YOU FIND THIS KIND OF RETURN APPEALING TO

YOU PLEASE CALL ME AND I WILL BE HAPPY TO

TAKE ALL THE TIME NEEDED TO EXPLAIN. (Emphasis in

original.)

Still another registered representative used worksheets which "showed

potential qains of up to 189 percent on proposed options transactions.

Given these extraordinary results, the terminology found on one sheet,

in which the options writer is called the "banker" (and the purchaser,

the "gambler"), seems understated.

415

Exaggerated return figures are found in worksheets for several
reasons. A frequent reason is the omission of certain transactions
costs such as commissions and interest costs, which can have significant
impact on the profitability of an options transaction,
b. Selective reporting

The Options Study has also found worksheets in which return
figures seemed attractive because the presentation showed only the
most profitable possible results and omitted disclosure of the less
profitable possibilities for the recommended transaction. In contrast,
the Ootions Study did not encounter a single instance in which any
anticipated dividend — which would increase the profitability of the
transaction — was omitted from an options worksheet computation.

Worksheets also often ignore the possibility of loss which might
came about because of a decline in the price of the underlying stock,
particularly with respect to covered call writing strategies. For
instance, one worksheet form used by registered representatives
in several major firms to describe covered writing situations sets
forth the following:

PERCENTAGE RETURN ON SELLING OPTIONS

If Stock Is Called If Stock Is Not Called

(Assume stock remains at current price)

416

The two assumptions presented would generally result only in profit
to the customer (provided that the sum of the options premium and any
stock dividends received is greater than all commission costs incurred) .
Nd mention is made of possible declines in stock price, which can result
in loss to the customer .

A different kind of selective presentation can distort results when
performance reports are used as selling tools as, for example, if only
the results of successful accounts are shown to prospective customers
while accounts showing losses are not shown,
c. Erroneous calculations
Exaggerated figures may also come about because of errors in
calculation. Worksheets and performance reports are usually prepared
by individual registered representatives, not by management, and they
are error-prone. The Options Study has encountered several situations
in which registered representatives prepared either worksheets
or performance reports that contained errors. These errors almost
always inflated the profitability of a proposed transaction or of
a customer's account. For example, the Options Study reviewed one
worksheet in which a registered representative computed the customer's
commission costs in the proposed transaction as additional income to
the customer .

When erroneous or inaccurate return computations are found in a
performance report both the customer whose account has been "analyzed"

417

and prospective customers who are shown the report may be misled.
An example of the or obi ems which may arise when performance
reports are miscalculated and then used as a sales tool is found
in the activities of an options sales team operating in the branch
office of a maior retail brokerage firm.

Initially, the sales team solicited four customers to participate
in a "pilot Droqram" of options investment. After several months of
options trading, the accounts of these four "pilot" customers were
analyzed for performance by the sales team. One of the registered
representatives calculated the following favorable returns on investment
for the various types of strategies used in the "pilot program":

(1) Agqressive Call Buying 7 mos. 23.59%

(Annualized ) 40. 44%

(2) Agqressive Covered Writing 7 mos. 35.06%

(Annualized) 60.09%

(3) Conservative Covered Writing 7 mos. 22.09%

(Annualized) 37.87%

These figures were false, tone of the four customers involved
in the "pilot program" earned these rates of return. In fact, one of
the customers lost $4,280 during his involvement in the program, and
another customer earned only $3.54 on an $8,100 investment. The other
two participants earned only a 3 percent return on their original investment
In addition, none of these customers participated in the "pilot program"
for the full seven months as depicted in the reports.

418

These incorrect reports were given to the customers involved
in the "pilot program" and subsequently were used as promotional
materials to solicit new options customers at a series of seminars
conducted by the sales team. Many of these new customers were led
to believe that they would enjoy comparable returns if they par-
ticipated in the sales team's new "managed options program."

As a service for certain of these new options customers, the sales
team also prepared periodic performance reports which purported to
reflect all the transactions that had occurred in each customer's
account during the period reported upon, along with the profits and
losses incurred as a result of those transactions. All of the reports
were inaccurate; they generally inflated the equity value of the customer's
account and reflected profits when, in fact, losses had occurred.
The following table sets out the reports sent to customers - and
the corrected figures :

Reported

Actual

Equity

Customer's

Profits

Reported to

Actual

Customer

Month

(Losses)

Customer

Equity

June, 1977

$ 479

($ 5,104)

$10,201

$ 2,204

June, 1977

4,230

( 11,361)

34,730

6,409

June, 1977

2,921

( 3,616)

35,203

3,265

June, 1977

2,850

( 6,224)

21,185

12,200

March, 1977

( 450)

9,670

9,935

June, 1977

885

( 3,582)

13,985

14,243

March, 1977

175

( 1,506)

4,200

2,122

June , 1977

3,608

( 1,783)

13,960

6,534

June, 1977

964

( 3,438)

No Report

March, 1977

759

( 4,896)

11,900

6,833

419

d. Deceptive timing

Performance reports, to be useful to a customer, must contain current
information since fluctuation in stock or options prices can dramatically
alter the results of options trading. Therefore, information which is
not current can be as misleading to the options investor as erroneous
information. The Cot ions Study encountered some performance reports,
however, which included information about a customer's account which
was not current. In one instance, a report that was only one week
out-of-date told the customer that he "should probably realize . . .
S4,500 as Drofit for the coming quarter," when, in fact, because of
movements in stock orices and transactions after the date of the report,
the customer had already lost or was in danger of losing almost all of
the $4,500 "profits" by the time he received the report.

e. Controls

(1) Standardized forms
A serious shortcoming with regard to options worksheets is the
absence of a standardized format throughout the securities industry and
even within firms. Worksheet forms created on an individual basis
by reqistered representatives are more likely to contain arithmetic
errors and to have serious disclosure deficiencies than those provided
by the brokerage firm. In addition, lack of a standardized format
increases the difficulty of analyzing a worksheet for supervisory
Dur poses .

420

Almost half of the firms in the industry group sample already provide
some sort of standard form options worksheet for use by their registered
representatives althouqh not all firms require use of the standardized
form. Several firms provide worksheets for registered representatives
but mark those forms "FOR INTERNAL USE ONLY" or "NOT FOR DISTRIBUTION
OUTSIDE OUR FIRM." Making standardized forms available to registered re-
presentatives is an insufficient control device, however, if registered
representatives, nevertheless, are permitted to use their own options
worksheet forms. In one firm which provided standard form worksheets
for internal use only, certain registered representatives sent to customers
other options worksheets which were never shown to any supervisor of
the firm and which gave customers the impression that the options trades
described were "no-lose" situations.

A standard form worksheet which provides an organized presentation
of all information and disclosures relevant to an options transaction
and which is uniform throughout the industry would help both investors
and registered representatives understand the precise nature of the
options transaction being proposed and, at the same time, provide a basis
for prompt audit by the firm or regulators.

421

Accord inqly, the Options Study recommends:

TOE SELF -REGULATORY ORGANIZATIONS SHOULD (1) DEVELOP
UNIFOFM STANDARDIZED OPTIONS WORKSHEET FOFMS WHICH
REQUIRE DISCLOSURE OF ALL RELEVANT COSTS AND OTHER
INFOFMATION, INCLUDING AN APPROPRIATE DISCUSSION
OF TOE RISKS INVOLVED IN PROPOSED TRANSACTIONS;
(2) PROHIBIT THE USE OF ANY OPTIONS WORKSHEETS
OTHER THAN THE NEW UNIFORM FORMATS AND REQUIRE
THAT NEW WORKSHEETS BE FULLY COMPLETED WHENEVER
USED.

Performance reports created by registered representatives on an
individual basis can likewise be confusing, misleading, incorrect,
and difficult to audit. Most firms in the industry group sample
rely almost entirely on correspondence reviews to monitor the use of
performance reports. However, simple correspondence review procedures
are not adeouate to deal with the potential problems to customers
caused by performance reports. What is called for is detailed financial
analysis to evaluate these reports for fairness and accuracy which
many supervisors have neither the time nor the expertise to perform.
Moreover, many brokerage firms do not provide their sales office
suDervisors with the information or assistance necessary to accomplish
such an analysis on a reasonably prompt basis.

In all of the cases involving misuse of performance reports
reviewed by the Options Study, the brokerage firm did not have effective
controls to monitor a registered representative's use of performance
reports. One solution to the problem of ad hoc performance reports
is to produce some form of computerized performance report for

422

individual customer accounts. Eighteen percent of the industry
qrouo sample follow this practice. Even though these computerized
reports may be misused by particular registered representatives,
they appear to offer some protection to customers by eliminating
the erroneous calculations so likely to occur when performance
reports are prepared bv individual registered representatives.
Computerized reports also introduce a degree of standardization
which facilitates supervisory review.

(2) Recordkeeping and inspection of worksheets
In order to properly monitor the use of options worksheets, firms
must have adeouate record retention procedures. Frequently, however,
neither options worksheets prepared for "internal use" nor those shown
or sent to customers are kept as part of the firm's permanent records.
Eiqhty-seven percent of the industry group sample indicated that they
do not reauire registered representatives to keep copies of options
worksheets shown to customers and 65 percent do not specifically
reauire retention of worksheets sent to customers. Even those firms
which reauire retention of worksheets do not always insist that
they be kept for an adequate period of time. When options worksheets are
retained, they are most commonly kept as part of a branch office's
general correspondence file where they are difficult to retrieve
and collate with other documents for analysis of trading in an options
customer's account.

423

In view of the problems discovered concerning the use of options

worksheets, the Options Study recommends:

THE SELF-RECULATORY ORGANIZATIONS SHOULD REQUIRE
THAT COPIES OF ALL OPTIONS WORKSHEETS WHICH ARE
SHOWN OR SENT TO EXISTING OR PROSPECTIVE CUSTOMERS
OR WHICH ARE USED AS THE BASIS FOR ANY SALES PRE-
SENTATION TO A CUSTOMER BE RETAINED BY MEMBER
FIRMS FOR AN APPROPRIATE TIME IN A SEPARATE
FILE IN THE SALES OFFICE IN WHICH THE CUSTOMER
HAS AN ACCOUNT.

Record retention procedures can also help control the use of
oerformance reports. Several firms already require that all performance
reports be keot permanently but most firms require only that all
performance reports be retained for three years or less. Inspections
conducted bv the Commission's staff indicate, however, that even when
oerformance reports are kept, they are sometimes buried in miscellaneous
correspondence files and are, thus, not available for easy and prompt
examination in connection with the analysis of a customer's account.

Because the popularity of performance reports can be attributed, in
part, to the inadeouacies of regular options account statements, im-
plementation of the Options Study's recommendations with respect to
improving such statements may make the use of performance reports
less attractive to registered representatives. Nonetheless performance
reports probably will continue to be used as a sales device. The procedures
recommended below may alleviate the problems with performance reports
identified bv the Options Study.

424

The Options Study recommends:

THE SELF-REGULATORY ORGANIZATIONS SHOULD AMEND
THEIR RULES TO REQUIRE THAT:

(1) ALL PERFORMANCE REPORTS SHOWN, GIVEN OR SENT
TO CUSTOMERS BY MEMBER FIRMS BE INITIALLED
BY THE FIRM'S LOCAL OFFICE SUPERVISOR TO INDICATE
A DETERMINATION BY THAT SUPERVISOR THAT THE
PERFORMANCE REPORT FAIRLY PRESENTS THE STATUS
OF THE ACCOUNT OR THE TRANSACTIONS REPORTED
UPON;

(2) COPIES OF ALL SUCH PERFORMANCE REPORTS SHOWN,
GIVEN OR SENT TO CUSTOMERS BE RETAINED BY
MEMBER FIRMS IN A SEPARATE FILE AT THE LOCAL
SALES OFFICE;

(3) REGISTERED REPRESENTATIVES BE PROHIBITED
FROM SHOWING ANY PERFORMANCE REPORT OF THE
OPTIONS ACCOUNT OF ONE CUSTOMER TO OTHER
EXISTING OR POrENTIAL CUSTOMERS, UNLESS
COMPOSITE FIGURES WHICH FAIRLY PRESENT
THE PERFORMANCE OF ALL THAT REGISTERED
REPRESENTATIVE'S CUSTOMER OPTIONS ACCOUNTS
DURING THE SAME PERIOD ARE ALSO SHOWN.

425

G. PROMOTING OPTIONS - INVESTMENT PROGRAMS

1 . Introduction

A common promotional device used to sell listed options is the
"options program," an investment plan employing the systematic
use of an ootions strategy. Programs generally involve a repeating
cycle of investments, made for the participating customer by a
reqistered representative pursuant to either a formal or informal
grant of discretion from the customer .

Options programs are generally of two types: (1) those sponsored
and manaaed centrallv by a brokerage firm or its investment advisory
affiliate; and (2) those promoted and managed locally by registered
representatives or their affiliated advisers. There are many
variations of these two program types.

More than 27 percent of the brokerage firms in the industry
group sample offer to their customers "managed options accounts" ,
usually under the central control of an investment manager chosen
by the firm. Almost all firms offering such services require that
participating customers have substantial net worth and income —
and, in some cases, a great deal of sophistication in financial
matters. These programs usually employ only covered call writing
strategies which are sometimes further limited to the writing of
options only against stock which was in the participant's portfolio
before he entered the program.

426

One brokerage firm's description of its centrally managed options

proqram reflects the generally conservative approach of firms toward

such programs:

Managed option accounts are offered to customers on a
highly selective, individualized basis. ... [T]r ad ing decisions
are made by senior officers of the firm who have long and
successful option management histories. This service is
only offered to customers who have both the sophistication
necessary to evaluate the risks involved and the financial
means to absorb loss.

In contrast to the conservative approach and high standards
which many firms attempt to maintain for their centrally managed options
proqrams, the same firms often have poor or inadequately enforced
standards concerning "programs" run by local options "experts".

2. The Attraction of Options Investment Programs

To customers who find options complex and confusing, or who have
insufficient time to follow their investments, an options program may
apoear to be an attractive way to participate in options trading.
By joining a program, the participant avoids the frequent and often
difficult investment decisions which are necessary in options trading,
and instead relies on the judgment of an industry professional
who is often touted as an "expert" in options.

To the registered representative and his brokerage firm, options
programs offer an obvious attractive opportunity to earn
substantial , steady commissions from the repeating investment cycles
which characterize such programs. The commission generating oppor-
tunities in just one cycle of a simple covered writing program are
deoicted in Figure I:

427

FIGURE I

COVERED CALL WRITING

VARIATION ONE - SIX COMMISSIONS

Step I

Sell

securities
presently
in account

Step 2

(calls exercised;
Step 3

Step 4

Purchase Write CUSTOMER Deliver

OPtionable calls v. ASSIGNED stock

securities securities EXERCISE

Step 5

Replace
stock ;
write more
calls

(sc

(sc)

(ocr

(sc)

(sc) (oc)

VARIATION TWO - FIVE COMMISSIONS

(calls repurchased before expiration]

Step 1

Sell

securities
presently
in account
(sc)

Step 2

Rjrchase

OPtionable

securities

(sc)

Step 3

Write
calls v.
securities

(oc)

Step 4

Repurchase
calls

(oc)

Step 5

Write more
calls

(oc)

VARIATION THREE - FOUR COMMISSIONS

(calls permitted to expire)

Step 1

Step 2

Step 3

Step 4

Step 5

Sell

securities
presently
in account

FUrchase

ootionable

securities

Write
calls v.
securities

Calls expire

without

exercise

Write more
calls

sc)

(sc)

(oc)

(no commission) (oc)

* "sc" = stock commissions
** "oc" = options commissions

428

In any of these variations, the cycle is repeated for the investor

who continues to participate in the program. At each step (except as

noted), there is at least one commission charge.

To convince their salespersons to sell listed options, some brokerage

firms emphasize how options investment programs can generate substantial

commissions. At the behest of his firm, one registered representative

told his peers:

My goal this year (my #1 year in production)
is $150,000. I feel I have a fair start at $75,000
for the first five months. Options have accounted
for approximately 50%. Without the concept of
a packaged program, I doubt if these figures
would be here this soon . . .

3. The Selling of Options Investment Programs
a. Sales presentations

The revenue producing qualities of managed options programs cause
firms to market such proqrams heavily. The promotional materials usually
stress the use of computers, "mathematical models", statistical analysis,
economic models, and other features which highlight the sophistication
of the program. The Options Study has found that these "highlights"
are sometimes merely a selling device.

Another benefit of managed options programs stressed in pro-
motional materials is the commitment of the registered representative
or the firm to monitor closely the customer's account in order to
avoid losses. As one registered representative put it:

"I stand ready to assume the total responsibility
of monitoring the option positions on a daily basis
so that your necessary involvement need be no more
time consuming than depositing the checks as
they come in ."

429

Manv ootions customers have relied heavily on their registered
representatives to monitor their accounts. Unfortunately, this reliance
is sometimes misplaced. Particularly where small investors are concerned,
reqistered representatives may find monitoring customer options accounts
a nuisance. One national firm, that regularly advertises its willingness
to handle small customer accounts, related to its sales force how a
successful salesman ("Rick") dealt with this problem — simply by recom-
mend inq far-term options series to small customers:

With insignificant option writing accounts
($10,000-$15,000) [Rick] suggests that he
writes options as far out as possible and
therefore has the customer participating,
but not necessitating customer review and
personal contact. This allows [Rick] to
continuously monitor his major accounts and
constantly uporade his clientele through
aggressive prospecting. There is no diffi-
culty understanding [Rick's] success.

A salesperson's failure to monitor options accounts can cause
customers to experience substantial losses, as the following case
illustrates:

A retired couple who previously had owned only municipal bonds
and "blue chip" securities was persuaded to entrust $100,000, more
than half of their net worth to a registered representative's uncovered
call writing program. The couple claim that they were told that such
a program was "conservative" and "absolutely safe". When the couple
asked about oversight of their account, they were assured by the
registered representative that he "would handle their account as if
it belonged to his parents."

430

After six months of options trading, the registered representative
called the retired couple and informed them that their account had lost
between $6,000 and $8,000 and that he was leaving the firm's employ.
The couple then requested that their account be closed and their capital
returned to them. Tney were advised, however, that margin requirements and
"pending commitments" of the program made withdrawal of equity unwise.
Instead, their registered representative proposed to turn their account
over to one of his colleagues who would undertake to close the account.

During the next several months, the couple complained several
times about the firm's lack of progress in closing the options account.
Each time they were told that more time was needed to unwind the
proqram. In fact, the firm's failure to monitor this account permitted
losses to accumulate in excess of $90,000.

The couple later explained how they came to repose such confidence

in their reqistered representative:

At the beginning [our registered representative]
did occasionally keep us generally advised as to
his investment direction but he felt that since we
were not completely acquainted with options pro-
ceedings we should trust his and [the brokerage
firm's] judgment since that is what they were
being paid to provide.

b. Prepared sales presentations

Some options programs are sold by means of sales presentations

prepared by the brokerage firm for registered representatives who

themselves may not fully understand the program. Tnese prepackaged

sales presentations for options programs are sometimes popularized

by area "options co-ordinators" who may maintain a network of

"ootions product leaders" throughout the branch offices of a firm.

431

In one national brokeraqe firm, a regional options coordinator prepared
the following script for his firm's representatives to use in selling
listed options:

(1) With an "established customer":

— "George, you have had a bad five years. Things have not
worked out the way we have planned. You have had the
risk inherent in the ownership of your stocks during all
those years. If you are still willing to accept that risk
and if vou are willing to accept a 15-20% annual return
on your investments, I would like to discuss a program
with you. What I am asking is would you be willing
to double your money every four years?"

(2) The "portfolio approach"

"You have a $100,000 portfolio. Do you know that I can
rent that out for $80/day, $560/week? Are you making that
kind of return on your money now? [Customer]: 'I want
to talk to my accountant, my wife, etc.' [You]: 'How
long will that take?1 [Customer]: 'Oh, about a month.'
[You]: 'If you had an apartment building worth $100,000
would you leave it unoccupied for a month? I can get
you $2,400 in the next 30 days by renting your portfolio,
let me know."

"Work up two portfolios.... [The] [f]irst
should be a conservative one - BS, T, HR,
RCA, etc. This one will sell the program to
the customer. Should title it 'Suggested Port-
folio'.... Set up a second, more aggressive
portfolio. Let customer see it but do not
emphasize it. You try to sell him the conserva-
tive one. Chances are he will opt for the aggres-
sive one."

432

— "Be sure you have portfolios written up before you
make your call. If you say, "I'll call you tomorrow
with some ideas", you have lost your impact. Fort-
folio should consist of 10 stocks. If he doesn't
like two, eliminate them. You have just sold eight
stocks."

(3) "Converting" a customer into an options writer;

— "When you have him sign the papers, be certain you
get the first order with them. Cnce he has signed
the papers and given you the order, he is psycho-
logically ready. You have helped unburden him
making an immediate $100,000 decision and he is
thankful for that."

— "Cnce the RCA is done, call him and tell him you will
mail him a check tomorrow for the option premium.

It will probably be the first profit he has seen in
five vears. It will improve his disposition immeasur-
ably."

— "...lb earn 15-20% you must create the entire portfolio
This is the standard pitch if the customer does not
choose to complete the portfolio. You must let him
know that he has assumed the responsibility for any
underperformance in the program."

SalesDersons are then admonished that, after the customer signs the
ootions papers, they should "get commitments for [regular] referral [s]
and [future] addition[s] of capital ."
c. Team tactics
Programs run out of local sales offices are frequently formulated
and promoted by sales management "teams". These teams may consist
solely of registered representatives employed by the firm or may
include an investment advisor from outside the brokerage firm. Typically,
one or more members of the team are the business getters — soliciting

433

customers. The other acts as the "money manager" or "options specialist"

who will meet the customer, if at all, only during the closing sales

presentation when the entire team seeks to impress the customer with

its exDertise or the sophistication of its "system".

Customers sometimes complain about the high pressure sales tactics

employed by seme of the teams selling listed options, and, indeed, the

Cotions Study has seen a number of cases in which sales^nanagement

teams were enqaqed in selling practice abuses. Nonetheless, industry

literature and internal documents of brokerage firms, encourage the

establishment of sales teams to prospect for new business, particularly

options business. For example, one regional options coordinator reported

to his network of registered representatives in his monthly newsletter:

Which offices are growing the fastest in options
and how are they doing it? [Branch A] has organized and
formed more teams than the NFL. These groups are selling
programs and are starting to build large equity pools.
They are concentrating on selling and not on out-smarting
the market or overmanaging the equity they have. Watch
them over the next few months. (Emphasis in original.)

Cf the firms in the industry qroup sample, 84 percent allow registered

representatives to split options commissions, normally an indication

that sales-management teams are welcome within the firm.

d. Particular options investment programs

(1) The covered call writing program.

Covered call writing programs appear to be the most popular of

all options programs.

Sales presentations for covered writing programs frequently emphasize

the "income" producing aspects of covered writing. One salesman testified

434

about the way in which he sold these programs:

...I tried to get the customer to think in
terms of checks coming to his house; the
dividend checks would come in, the option
premium would come in, get him thinking in
terms of receiving five checks a year, six
checks a year, rather than four. Painting a
mental picture of that.

Sales presentations for covered writing programs also emphasize their

"conservative" nature. An excerpt from a mailer sent to a random selection

of potential customers by a registered representative in a major brokerage

firm is tvpical of the "conservative" approach:

Che of the fastest qrowing segments of the
securities business consists of the conser-
vative investment strategy of writing options
on common stock. Using this technique, you
can expect to substantially increase the current
yield on existing or purchased stock positions
while at the same time reducing your market risk.

Still other sales presentations focus on the "risk-reduction"

features of call writing programs. Cne prepared sales presentation

reviewed by the Options Study has the registered representative telling

the potential investor :

We no longer care whether the market is up 10,
up 50, down 50. We have transferred this risk
of ownership to the option buyer .

What most sales presentations do not stress is the risk of

covered writing programs — or covered writing in general. The

principal risk is that the underlying stock will decline in value

far more than the amount received by the program participant in

435

premiums on the options he writes. The risk is especially great if the
stocks nurchased under the programs are volatile.

For example, a customer during 1977 was persuaded by his
reqistered representative to switch his tax free and fixed income
securities into a covered writing program. The registered representative
had emphasized that such a program was "conservative" but did not
exdain that the stocks purchased in the program were less "conservative"
than the securities already held by the customer. Moreover, the customer
misunderstood the meaning of "conservative." He understood a "con-
servative" program to be one which had income and capital preservation
features similar to his previous fixed income securities investment
olan. The customer was therefore completely unprepared for the losses
which resulted from a decline in the price of the stocks into which
he had been switched. In only a few months this investor suffered
losses on his newly assumed stock positions in excess of $7,500, almost
twice the options premium "cushion" he had received from writing calls
on the stocks.

When the investor complained to the brokerage firm, the firm
resoonded that owninq a stock and writing calls against it was
more "conservative" than merely owning that same stock. Tne firm never
dealt with the investor's complaint that he would never have purchased
such volatile stocks if he had been made aware that the risk of loss
was so large.

436

Although qreater risks of loss on the underlying stock are associated
with writing covered calls on margin, because of the larger positions
taken through borrowing, these additional risks are often not explained
to customers. The lack of attention to the risks of trading options
on margin is all the more surprising in light of the fact that brokerage
firms actively encourage salesmen to open margin accounts for options
customers by emphasizing the larger commissions available from margin
accounts. In addition, some options strategies can be pursued only in
a margin account.

An example of the risks of trading options on margin is found in
one discretionary account analyzed by the Options Study.

On June 1, 1977, the investor's account held a large position in
one "blue chip" eouity security with an aggregate market value of
$855,000. Qi that date, the investor was convinced by her registered
representative to deposit this stock in a newly opened margin account
in which covered options were to be written. The borrowing power
created was used to finance the purchase of several more volatile
stocks against which listed call options were written.

By June 1, 1978 the same investor had experienced the following
gains and (losses):

loss on Stocks - realized (132,500)

Loss on Stocks - unrealized (177,900)

Gain on Expired Options 35,700

Dividend Income 10,600

Interest Expense ( 44,400)

Net Loss (308,500)

437

These losses represented 36 percent of the investor's initial account
eauity. Had the investor refrained from margined call writing against
volatile stocks and merely held her "blue chip" position, her account
would have decreased by $156,000 or 18 percent. Again, this account
received a sales pitch which emphasized the conservative features of
a covered call writing program, but was not apprised of the special
risks attendant to investing in options on margin.
(2) Exotic and advanced options programs

Some registered representatives and firms offer managed options
oroqrams which employ complex trading strategies that even very
sophisticated investors cannot always understand. Frequently, the
risks of these programs are misrepresented to customers. For example,
an uncovered call writing program is generally acknowledged to
be a highly risky undertaking. However, the Options Study encountered
situations where salespersons claimed that such programs had "capital
preservation" features or were "not speculative". Variations of un-
covered writing programs (e.g. , ratio writing and partly covered
warrant-option hedges) have also been sold to investors as though
they were simdy another form of "conservative" covered writing
program.

In addition, the complexities of advanced programs can serve to conceal
Questionable trading activities by registered representatives and, thus,
bear special risks for investors. For example, one middle-aged widow
entrusted common stock of twelve blue chip equity issues to her registered

438

representative's "aqqressive" discretionary trading program. The registered
representative immediately liquidated the investor's portfolio (generating
$1,600 in stock commissions) and used the proceeds of $113,000 to establish
the following positions for the investor's accounts:

7 opening uncovered call sales

17 spreads (both vertical spreads and time spreads)
15 ODening call purchases

4 short sales of stock hedged with call purchases (synthetic puts)

Althouqh the investor was told that her accounts were well hedged
and diversified as a resuit of this trading, the hedges dissolved
and the initial diversification of the account disappeared within
weeks. First, the investor's accounts were assigned fourteen exercise
notices, forcing her to buy stock to cover uncovered short call positions
and, at the same time, eliminating one side of some spread positions.
As a result, the investor's accounts realized trading losses, additional
commission costs, and incurred a disproportionate increase in risk.
During the same period, some of the account's long call positions
which were part of time spreads expired worthless, eliminating
one side of several spreads ("leglifting" ) and leaving the account
subject to the greater risks of now uncovered short call options
positions. (Time spreads with a short position having a more distant
maturity than the long position, are generally considered to be more
risky than those in which the long position has a more distant
maturity.)

439

After four months of options trading, when the customer withdrew
discretionary authority over the account, her account had suffered
losses of approximately $50,000, more than half of which were paid
to the firm as commissions and margin interest,
e. Conclusions

Options investment programs aggravate the regulatory problems
involved in options selling. The Options Study believes that recom-
mendations put foward elsewhere in this chapter of the report will
remedy many of these problems. Of particular importance are the
recommendations concerning discretionary options accounts, systematic
reviews of account activity and control of performance reports.

440

H. OPTIONS TRADING IN CUSTOMER ACCOUNTS

1. Introduction

The combination of an option's short life and the complexity of
options trading in general has made it apparent to many customers that
they have neither sufficient time nor understanding to monitor with
adequate diligence the trading activity in their own accounts. As a
conseauence, many customers rely heavily on their registered representatives
for options trading decisions. This reliance, in many cases, is so great
that registered representatives can effectively control all trading
in these customers' options accounts. Since this control is not always
exercised wisely or fairly, problems can arise.

One major problem for the customer is unsatisfactory performance by
his registered representative. This less than satisfactory performance
may result from the salesman's simple lack of knowledge about options
tradinq, or from the temptation to abuse the customer's account arising
from the commission potential of options trading. In some cases,
customer losses are the result of both the lack of knowledge and also the
self-interested conduct of registered representatives.

Abuses, such as excessive and unauthorized trading, often go
unchecked until substantial losses are sustained by the customer . Tne
delay in detecting such problems occurs because supervisory systems are
inadequate, or because the customer is so confused by his account statements

441

- or misled by inaccurate performance reports - that he cannot determine
the result of trading in his account. These and other problems that seem
to arise often in the accounts of options customers are discussed below.

2. Excessive Trading

As noted earlier in this chapter, the industry's usual commission
structure for options makes them an attractive sales product for
commission-dependent salesmen. A desire to increase their earnings can
tempt registered representatives to effect excessive options trades
in customer accounts with the primary purpose of generating commissions,
a. Examples of excessive trading

The temptation for a registered representative to trade an options
customer's account excessively is illustrated by the following case
concerning a widow for whom some form of options trading may have been
suitable. When the customer's husband died, he left her more
than $400,000 in securities. Since the widow had never participated
in the family's financial affairs, she readily entrusted her entire
securities portfolio to a local representative of the firm with which
her husband had dealt. Starting in 1970, and for several years, that
registered representative primarily traded equities in her account,
following the pattern that had been established in her husband's account;
an average of 40 trades per year were effected and annual commissions
averaged approximately $7,300.

442

In 1974, however, (the year following commencement of listed options
tradinq) the registered representative began trading listed options
in her account. In that single year, he effected more than 200 trades
and qenerated nearly $40,000 in commissions, more than 25 percent of
his total gross commissions for the year. While the loss of $200,000
in the account cannot be attributed solely to options trading, options
transactions contributed significantly to these losses and provided
the vehicle by vhich this salesman earned extraordinary commissions
at the expense of this unknowing client. The following table summarizes
the activity in this account:

TABLE II

Commissions as

percentage of

Year

Number of Trades

Commissions

account equity

1969

1970

4,519

0.9%

1971

3,533

0.7

1972

13,567

2.8

1973

6,745

1.4

1974*

243

39,693

10.7

1975 (5 months)

20,020

6.9 (5 months)

* beqan tradinq options

Many other situations involvinq apparently excessive tradinq
of options accounts have come to the attention of the Options Study. 38/

38/ These cases come from several sources, including: the review of
customer complaints submitted by broker/dealers or received
directly from customers; Commission enforcement actions; private
litigation; the disciplinary proceedings of self -regulatory organi-
zations; and the reports of broker-dealer inspections by self -regulatory
organizations and the Commission's staff.

443

From these cases the Options Study has identified certain factual
natter ns which seem to be commonly associated with excessive trading
problems .

( 1) The obvious churning case
Excessive trading of a customer's account is often accompanied by
other fraudulent conduct. For example, the Options Study reviewed one
case where a national brokerage firm and several of its employees
apparently were engaged in concurrent excessive trading, misrepre-
sentation, suitability and supervisory violations. Two registered
representatives using a variety of misrepresentations, induced fourteen
customers to open discretionary accounts; each was to be managed in
accordance with the registered representatives' options trading program.
These fourteen customers invested a total of $372,550, suffered losses
of $117,122, and were charged commissions of $98,588. Although the
average account was open only 12 months, average commission costs
exceeded 25 percent of the money invested. Tne table below summarizes
the results of the trading in these accounts:

444

TABLE

III

Commissions as

Losses

Total

A Percentage

After

Percentage of

Customer

Investment

Commissions

Of Investment

Commissions

Investment Lost

$ 77,566

$18,401

23.72%

$ 22,494

29.00%

144,092

18,177

12.61%

9,191

6.38%

5,405

3,820

70.68%

5,391

99.74%

14,867

1,212

8.15%

5,303

35.67%

28,425

15,706

55.25%

24,753

87.98%

16,122

9,993

61.98%

14,487

89.86%

3,943

1,655

41.97%

2,228

56.51%

9,732

4,018

41.29%

3,634

37.35%

10,844

445

4.01%

927

8.92%

18,220

7,377

40.49%

5,365

29.45%

8,558

4,472

52.27%

4,824

56.37%

18,177

3,605

19.83%

8,982

49.42%

11,730

4,085

34.83%

5,609

47.82%

4,869

5,622

115.47%

3,894

79.98%

Total

$372,550

$98,588

26.26%

$117,122

31.44%

Account "G" belonged to a young serviceman and his wife. This
family's total income was $23,000, and their net worth approximately
$20,000. Neither the serviceman nor his wife had any prior investment
experience in the securities markets. In late 1976, they approached
this national brokerage firm to determine if they could find an investment
offering a return higher than they were receiving on their $4,000 bank
savings account.

The two registered representatives recommended to the couple a "low risk"
options program - one which they represented offered returns on investment of
up to 35 percent. Enticed by this sales presentation, the couple deposited their

445

entire $4,000 of savings in a discretionary account with the brokerage firm.
During one year, the two registered representatives generated commissions of
about $1,600 (40 oercent of the equity invested), and lost more than $2,000
of the couple's original investment.

As part of the trading in this account, a series of discretionary
transactions were effected which had little or no investment merit.
For example, one of the registered representatives purchased 300 shares
of common stock and wrote three in-the-money calls against that stock.
The maximum gain to the couple from the trade, after deducting commissions,
would have been $199 if their options had been exercised and the stock called.
The couple Dlaced at risk $2,719 (the cost of the stock less the premium
received) while the commissions to the brokerage firm, which would be generated
if the stock were called, would have been $203. Several other trades in
the couple's account appeared to be worthwhile only for the registered
representatives and their firm or, at best, were only marginally profitable
for the customers.

(2) The retired school teacher

Excessive trading is often associated with inexperienced, unsophis-
ticated customers. A classic example is the experience of a retired
school teacher who had onlv limited experience in the stock market
and who had never invested in options. Her primary source of income, the
dividends from her portfolio of "blue chip" securities, was barely sufficient
to meet her needs. When a registered representative from a national brokerage

40-940 O - 79 - 31

446

firm advised her that returns of 40-50 percent were possible from
a program he had devised for trading listed options, she thought
she had found the answer to her income problem. Indeed, she was
so anxious to participate in his program that she permitted
the registered representative to misrepresent her net worth on the
options account information form. Such falsification was necessary
to secure aporoval of her discretionary options account since her
actual net worth did not meet the brokerage firm's minimum standard
for the salesman's "aggressive options trading" program.

When the customer's discretionary account was opened, in April
1977, account equity totalled $115,000. At that time, she signed a
statement indicating her goal of 35-40 percent appreciation and
acknowledging that achievement of this goal "may result in frequent
trades and substantial commissions." Despite this statement, she
did not appreciate the risk she had assumed, did not understand the
trading strategies employed, and could not comprehend her account
statement .

When trading was halted, after four months, the equity in the account
had declined to $64,000, a loss of $51,000. During this period, the
reqistered representative generated more than $25,000 in commissions,
an amount equalling more than 20 percent of the invested equity in the
account.

447

( 3 ) The wealthy executive

Excessive trading problems are not only associated with unsophisticated
customers, or customers of limited resources. Another type of excessive
trading case involves the customer who possesses a basic understanding
of options and is financially able to bear the risk of substantial losses,
but who does not have time to make the necessary trading decisions and,
accordingly, gives his registered representative discretionary authority
to manage his options account. One such investor, a wealthy real estate
executive, entrusted more than $500,000 to a registered representative
employed by a regional brokerage firm. In less than two years, the
account lost nearly 70 percent of the money invested; more than $80,000
of the loss - - 24 percent of the customer's average investment during

the period was collected by the brokerage firm as commissions.

Not only was the trading extraordinarily heavy in this account, but
the risks taken were also excessive even for a customer with financial
resources .

b. What is excessive trading?

The cases above illustrate instances of "excessive trading",
that is, trading in a customer's account which bears little relationship
to the customer's needs or objectives.

The ant i fraud provisions of the Federal securities laws have been
held to prohibit excessive trading, or "churning", by a broker-dealer
in a customer's account since such conduct violates the broker-dealer's
obligation to deal fairly with the public in compliance with the accepted
standards and practices of the profession. 39/ In Exchange Act Rule 15cl-7,

39/ Hecht v. Harris, Upham & Co. , 430 F.2d 1202, 1207 (9th Cir. 1970).

448

an antifraud rule applicable to over-the-counter securities markets,

the Commission defined churninq as follows :

[A]ny act of any broker [or] dealer .. .designed to effect
with or for any customer's account in respect to which
such broker [or] dealer... or his agent or employee is
vested with any discretionary power any transactions or
purchase or sale which are excessive in size or
frequency in view of the financial resources and
character of such account. 40/

Bv analogv many of the concepts of Rule 15cl-7 have been applied to
trading in other securities through the Commission's general antifraud
provision, Exchange Act Rule 10b-5. 41/

Proof of excessive trading involves several elements. The first element
of excessive trading is control by the registered representative over
the customer's account. Under Rule 15cl-7, control clearly exists where
the customer has expressly granted to a registered representative the
discretionarv authority to effect trades for his account. In addition,
control can exist even though no formal grant of discretion has been made
where the registered representative in fact exercises discretion over
the account. Therefore, trading which is either unknown to or unauthorized
by the customer is "controlled" by the registered representative. Control
can also be inferred if the registered representative significantly
influences the size and frequency of transactions in an account by

40/ Exchange Act Rule 15cl-7(a), 17 C.F.R. 240.15cl-7(a) .
41/ Exchange Act Rule 10b-5, 17 C.F.R. 240.10b-5.

449

reason of the trust and confidence placed in him by the customer. 42/
Such control has been found freouently in cases involving active trading
in eouity accounts where the customer was naive, unsophisticated, or
inexperienced in the workings of the securities markets. In other cases,
the accounts even of experienced investors who have consistently accepted
all recommendations from their registered representatives have been found
to be controlled by the registered representatives. 43/

The second element of excessive trading is a determination that
the transactions effected by the broker-dealer are excessive in size
or frequency in liqht of the nature and resources of the account and
the investment objectives of the customer . 44/

Since excessive tradinq "cannot be and need not be, established by
anv one orecise rule or formula," 45/ several factors are relevant

42/ See generally WOLFSON, supra note 15 at 1| 2.11.

43/ Russell L. Irish, 42 S.E.C. 735, 736-737 (1965), aff'd sub nom.
Irish v. SEC, 367 F.2d 637 (9th Cir . 1966), cert ."denied, 366
U.S. 911 (1967).

44/ In this regard, the prohibition against excessive trading is related
to the suitability doctrine in that churning is, by definition,
unsuitable for any customer. Both principles are designed to protect
customers bv obligating broker-dealers to act with customers' interests
uppermost in mind. The principal distinction between the two concepts,
however, is that churning applies to a series of transactions while
suitability also applies to each individual trade as well as a series
of transactions.

45/ Hecht v. Harris, Upham & Co., 283 F. Supp. 417, 435 (N.D. Cal . 1966),
aff'd, 430 F.2d 1202 (9th Cir. 1970).

450

in determininq whether an account has been traded excessively. The
nature of the account must be considered since the trading in an account
need not only be active but must also be inconsistent with the financial
circumstances and investment objectives of the customer. Fbr example,
a moderate level of activity might constitute excessive trading where the
investment objective of the customer is capital conservation, while the
same or hiqher level of trading might not be considered excessive in the
account of a customer seeking short term profits. In addition, whether
active tradinq in speculative securities is appropriate in a particular
account deDends, in part, on whether the customer is financially able
to bear the assumed risk of loss.

Since the motive behind excessive trading is usually the registered
representative's interest in generating commissions, evidence of trading
which is designed "to derive profits for [the broker-dealer or salesperson] ,
while disregarding the interest of the customer", 46/ while not necessarily
an element of the offense, is another factor to be considered. Fbr example,
the repeated purchase and sale of the same security absent any price change,
or the continous switchinq from one security to another with no apparent
rationale, mav reflect the broker's interest in generating commissions.
Options transactions in which the maximum potential profit is entirely
offset by the commissions charged raise similar questions as to the registered
representative's motives.

46/ Ibid.

451

c. The measurement problem

Tne most difficult problem relating to excessive trading is how to measure

activity. One factor frequently used to measure activity is the "turnover

rate" of an account. Various formulas have been used by the Commission

and the courts to measure the rate of turnover. These formulas typically

relate the total cost of purchases made for the account during a period

of time to the average amount invested in the account over the same period

of time. The fiqure derived is the turnover rate. Thus:

total cost of purchases for time period = turnover rate for time period
averaqe amount invested in account for
time oeriod

The formula above is known as the "Looper formula" 47/ and was

desinned for eouity trading. As used in this formula, purchases include

the full cost of all securities purchased whether on a cash or margin

basis during the oeriod to be measured. The amount of average monthly

investment is then calculated by totaling all cash additions to the

account, including cash deposits, oroceeds from the sale of securities,

and dividends; by deducting cash withdrawals; and by dividing the result-

inq total by the number of months in the period under consideration.

The Looper. formula accurately reflects the level of activity in an

an account only if the account is initiated with a cash deposit, if no

other securities are available for liquidation, and if no dramatic changes

occur in the prices of the securities held. If substantial securities

47/ LooDer & Co., 38 SEC 294 (1958).

452

positions are held in the account (or are otherwise within the discretion
of the reqistered representative) , the Looper formula substantially over-
states the degree of activity since the value of these positions is excluded
from the amount of averaqe monthly investment. For example, if $1,000,000
of stock is held in the account and a sale is made releasing $10,000 which
is then reinvested in the same month, the looper formula will yield a
turnover rate of Is

$10,000 (purchases) = 1

$10,000 (averaqe monthly investment)

Obviously, the use of such a turnover rate could be misleading if the

user believes that this rate measures the activity in the whole account.

Similarly, if the values of portfolio securities change significantly,

the formula will not accurately reflect the ratio of the amount of purchases

to the amount of total capital available for investment. This limitation

is particularly significant when an account includes highly leveraged options

positions which are subject to substantial price fluctuation.

A commonly suqaested modification of the Looper Formula is the in-
clusion in "net monthly investment" of all securities available for investment
at market value, calculated monthly. This procedure measures the rate of
turnover of capital available for investment during each month. Applying
this modification to the example above, the sale and purchase of $10,000
worth of stock in an account with an equity of $1,000,000 provides a
turnover rate of .01 per month, a more realistic indication of the activity
within the whole account .

453

Still, neither of these conventional formulations adequately measures
the impact of options trading on the activity in customer accounts since
they completely iqnore the effect of the sale of options contracts. An
account in which calls are sold against stock positions would not reflect
any activity unless the positions were closed through purchases.

The Options Studv has analyzed several alternative methods of measuring

activity in accounts which include options. One approach is to focus on

options alone, bv calculating the number of contracts bought or sold in

opening transactions per every $1,000 invested during the period under review.

Fbr example, consider the computations associated with a "conservative"

covered ootion writing account which has $10,000 in equity created by a 400

share long position. At any given time, the 400 share equity position serves

to cover the writing of up to four options contracts. Assume that the account

sells the calls nearest to expiration, repurchases the calls on expiration

date or allows them to expire, and then sells new calls. Using such a

strateav, the account would effect opening transactions for four contracts

once every three months, or for sixteen contracts during a one year period.

The contract activity index would be calculated as follows:

16 (contracts )/12 (months)

$10,000 (account eouity)/$1000 = .13

Table III illustrates the use of the contract index approach by applying

it to several customer options accounts which the Commission, in a

recent enforcement action, found to be excessively traded.

454

TABLE IV

Eouitv *

No. of

Duration

Contract

Account

Invested

Contracts

of Account

Index

$18,236

406

4 months

5.5

31,468

418

4 months

3.3

12,653

370

5 months

5.8

14,214

168

3 months

3.9

23,671

300

2 months

6.4

This method of measurement does provide a convenient basis for
comparinq the activity in various options accounts, but its failure
to reflect activity in other securities in the account is a serious
limitation, oarticularly since many options strategies are not limited
to ootions but also involve the underlying or other securities.

An alternative approach to calculating excessive trading focuses
on the amount of commissions generated by trading in the account rather
than upon the calculation of a rate of turnover. This approach analyzes
commissions earned as a percentage of investment during the period in
auestion. Since commissions ostensibly are the most common motive for
excessive trading, and since commissions provide a basis for comparison
of accounts usinq various investment vehicles, this aoproach offers one
logical solution to the need for a standard formula to measure trading
activity in customer accounts which include options.

* Eouity fiqures used in the calculations in Tables IV and V (below)
represent the customer's total investment in the account. A more
precise calculation would be to divide monthly commissions by account
eouity for that month (or average monthly commissions by average
account eouity) .

455

The use of commissions to measure excessive trading is illustrated
in the following table, using the sane accounts set out in Table III above:

TABLE

Monthly

Eouity *

Duration of

Commission/

Account

Invested

Commissions

Account

Equity

Sia,236

9,234

4 months

.13

31,468

18,975

4 months

.10

12,653

13,242

5 months

.21

14,214

8,215

3 months

.19

23,671

12,303

2 months

.26

In addition, the commission approach appears to be workable since
the accounting information necessary for this calculation is readily
available in the industry. Most brokerage firms currently calculate
commissions generated by each account on a monthly basis. They also
generally oossess the capability of calculating the equity in each
customer account on a monthly basis either within their existing
accounting systems or through the use of other currently available
technoloav. Thus, a simple formula of commissions as a percent
of account eouity on a monthly and year-to-date basis could provide
the needed measurement of activity for brokerage firm supervision of
accounts but would reouire no more information than is otherwise necessary
to maintain adequate surveillance over options accounts. While the use
of this formula cannot, by itself, specifically determine whether an
account has been excessively traded, it does provide a means of corn-
oar ison necessarv to such a determination.

* See note, o. 158.

456

d. Account review procedures to control excessive trading
Illegal excessive trading can occur only in an account over which
the registered representative exercises significant control. As noted
elsewhere, options customers freauently grant registered representatives
such control, either formally or informally. The Commission and the exchanges
have imposed rules which together require: (1) that every discretionary
options account be specifically authorized by the customer in writing;
(2) that every options trade in a discretionary account be initialed by
an ROP; and (3) that every order ticket for a discretionary options trade
be identified as such. 48/ Often, however, a registered representative
exercises discretion over an account without complying with these require-
ments. Such accounts, which lack the required documentation and authority
for discretionary trading, are normally treated by firm supervisors as
non-discretionary accounts.

Brokerage firms employ various controls in an effort to help insure that
trading in accounts is not excessive. One approach taken by several major
broker aqe firms is to prohibit discretionary accounts entirely or to restrict
such accounts to those managed at the home office. Other firms reject
this approach, taking the position that "a prohibition [on discretionary
accounts] merely chases them underground". Most firms, including those

48/ See, e.g., Rule 9.10, CBOE GUIDE (CCH) <| 2310. See also Exchange
Act Rule 17a-3(a)(b), 17 CFR 240.17a-3(a) (6).

457

which do not permit formal discretionary accounts, employ same automated

orocedures to detect and highlight a large number of trades effected

in, or substantial commissions qenerated by, all types of customer accounts,

A few firms have computer programs which isolate accounts with high trading

activity by calculatinq turnover rates using Looper-type formulas on

a monthly basis, while others use some combination of commissions or number

of transactions in an account. Customer accounts identified as overly

active usually are then reviewed to determine whether the activity is

justified or whether the trading is out of character for the account.

When firms identify a non-discretionary account with an unexplained
degree of tradinq activity, either the sales office manager or the firm's
comoliance department will frequently send the customer an "activity
letter" which purports to notify the customer about the unusual nature of
the activity in his account. Some activity letters describe the unusual
tradinq activity that prompted the mailing; others simply send greetings
from the branch manager and invite questions about the customer's account.
In either case, many activity letters appear to have been phrased
to protect the firm from liability rather than to inform the customer
that the manaqement of the firm is concerned about the activity in
the customer's account.

Moreover, most firms do not require that customers acknowledge
receipt of, or respond to, activity letters, and none of the firms in
the industry group sample reported routine procedures for sending a
second activity letter to a customer if the first is not acknowledged.

458

Many firms simply file the unanswered activity letters, to be used later,
if the customer complains, to demonstrate the customer's knowledge of
the activity in his account.

The self-servinq purpose served by activity letters is exemplified
by an internal memorandum sent from a compliance officer of a national
brokeraqe firm to one of his subordinates, with copies sent to a partner
of the firm. The memorandum, which expressed concern about options trading
losses in excess of $20,000 in a discretionary account managed by one
of the firm's registered representatives, contained the following hand-
written notation from the partner to the firm's chief compliance officer:

1) Has [John] analyzed other accounts of [the registered
representative] vhere they may be problems?

2) On accounts where commissions are large and trading
active, have we sent [a] "suicide letter" to [the] customer?
It cuts both ways but I think, on balance, it helps the
firm, vfriat do other firms do?

The chief compliance officer returned the memorandum to the partner with

the followinq notation:

[Bill] doesn't want [analysis of other accounts] done
until we have an actual complaint.

Can't send suicide letters to discretionary accounts.

Another weakness of compliance systems that rely heavily on activity

letters being processed by the branch manager is that many branch managers

themselves handle active accounts. Fbr example, a broker-dealer inspection

conducted by the Commission staff in 1978 disclosed one situation in which

the branch manager was personally responsible for an account that was

459

being excessively traded. The account opening documents reflected
that the customer was a retired man with an annual income of $12,000 and
a net worth of $100,000, who listed speculation as his only investment
obiective. Analvsis of this customer's monthly account statements revealed
that during a six month period in 1977, the account had effected 362 options
transactions, established postions worth $286,182, and had incurred losses
of $42,475, including $21,955 in in commissions. Because the branch manager
controlled both the trading in the account and the activity letter review
process, he did not notify the customer of the high degree of activity
in the account nor did the firm provide any effective supervision of the
account activity.

3. Unauthorized Trades

One of the most frequent complaints by options customers is that
their registered reoresentatives have effected unauthorized trades in
their accounts. Indeed the Commission has investigated many customer
comolaints of unauthorized trading and has found that these canplaints
are often an early warning of serious trading abuses, including excessive
trading. For example, the Options Study reviewed a situation in which
a customer had been out of the country and, therefore, out of contact
with his registered representative for several months. During that
oeriod active options trading nevertheless occurred in his accounts.
After this customer complained of unauthorized trading in his

460

account, an investigation revealed that the registered representative
had effected unauthorized options trades in the accounts of at least four
of his other customers, recommended options transaction not suitable for
other customers and engaged in excessive trading in still another customer's
options account.

Complaints about unauthorized trading in a customer's options
account are sometimes an indication that options trading is unsuitable
for the customer or that he is otherwise confused about the status of
his options account. The customer who does not understand a proposed
strategy or trading program may inadvertently "authorize" a transaction
without ccmorehending its nature or its risks. This confusion can result
in the sale of options investment programs to customers for whom such
orograms are unsuitable.

Too freauently, firms fail to investigate customer complaints of
unauthorized trading thoroughly. The apparent rationale for this failure
is a desire to discourage such complaints since some customers complain
that a trade was unauthorized when, in fact, the trade simply caused them
to lose money. The Qotions Study has found that often a firm's response
to a complaint will be to obtain the registered representative's version
of the episode and then resolve any conflicts in favor of the registered
representative .

461

In one instance, during 1977, a brokerage firm received complaints from
five options customers about a single registered representative. In each
case, the customer accused the registered representative of making mis-
representations, recommending unsuitable trades, doing unauthorized trades
and generally mishandling the customer's account. In addition, several
other customers of that registered representative complained of excessive
tradinq of their accounts. The firm responded that the customers presumably
knew what they were doinq at the time of the trades and, therefore, should
not complain (or blame the firm or its registered representative) because
their ootions transactions turned out badly. By mid-1978, this registered
representative had twice been the subject of self-regulatory disciplinary
oroceedings and had been sued by several customers.

Proper supervision requires that firms investigate customer complaints
of unauthorized trades. The Commission's investigations show that in many
instances, had suoervisors followed up on complaints of unauthorized trades,
they would or should have discovered excessive trading, uneconomic trading
and/or unauthorized trades in the complaining customer's account as well
as in the accounts of other customers handled by the salesperson concerned.

4. Uneconomic Trades

a. The trade with little or no profit potential

The adverse effects of the conflict between the interests of
commission-dependent salespersons and the interests of their customers can
be seen most clearly in instances where the registered representative

40-940 O - 79 - 32

462

recommends a transaction which will give him more in commissions than
his customer can hope to realize in profits. Indeed, the Options Study
has reviewed some trades in which the best possible outcome for the customer
was a loss. Fiqure II depicts one such options trade in which the customer1!
best possible outcome is a two dollar loss, regardless of the stock price
at exercise or exoiration.

463

Date of Transaction:
Strategy:
Position Assumed:

Cost to Establish Position:

Plus Commission

Caoital at Risk:

Best Possible Outcome:
for Customer

FIGURE I

February 6, 1977

Covered Writing

Buy 200 BCC § 27-1/8 §5425 Cost of Stock

Sell 2 BCC Nov 25 Calls e 3 ($ 600) Proceeds from

• 4825 Calls
$4825

+139

$4964

loss of $2

STOCK PRICE AT EXPIRATION OR EXERCISE

Profit

Profit 20

or
Loss

+$ 300

200
100
0
100
200
300
400
500

Loss

25 30

fesult before
Commissions and Dividend

/ Itesult after
Commissions
and Dividend

Maximum Profit
- $2

-$ 1000

Result

fesult

Before

after

Cost to

Stock Price

Proceeds of

Commission

Commissions

Establish

Expiration

Liquidation

and

Positions

Exercise

or Exercise

Dividend

Commission

Dividend

$4825

$10

$2000

$(2825)

$195

$55

($2965)

4825

4000

(825)

222

(992)

4825

4200

(625).

224

(794)

4825

4400

(425)

227

(59?)

4825

4600

(225)

229

(399)

4825

4800

(25)

230

(200)

4625

5000

175

232

(2)

4=25

5000

175

232

(2)

464

As can be seen from Figure II, the customer's maximum profit
on this covered writinq transaction, before commissions and dividends
was $175. However, after commissions are deducted, the best possible
outcome for the customer would be a loss of $2, even when projected dividends
are included. Of course, should the stock decline, the customer's entire
investment of $4964 miqht be lost. At the same time, the lowest possible
commission to the firm from the transaction would be $139, the commission
charqe for puttinq on the position. Should the stock be sold on exercise,
or liouidated at expiration, commission proceeds would increase.

Covered writinq is not the only strateqy which may be uneconomic
for the customer. Ootions spreads involve at least two, and possibly
four, separate oDtions commission charqes, in addition to possibly
two stock commissions. Althouqh these commissions can have a substantial
effect on the profitability of a spreading transaction, registered
representatives sometimes present to customers the profit and loss
ootential of spreading strategies without considering commissions.
Fiqure III deoicts a "calendar" or "time" spread * which, after
commissions, was at best a break-even trade for the customer.

* A calendar spread involves the purchase and sale of options on the
same underlying stock. The options have the same strike price but
have different expiration dates.

465

FIGURE II

Date of Transaction:
Strategy:
Position Assumed:

Cost cf Transaction: '
Plus CairLission
Total Cost

3est Possible Outcone:

January 27, 1975

Time Spread

BuylAHPOCT30e4 1/8 $412.50 Price of Option
Sell 1 AHP APR 30 § 1 7/8 ($187.50) Proceeds of Option Sale
225.00

$225.00

50.00

$275.00

Breakeven

STOCK PRICE AT EXPIRATION

$20

+300
200

100

Result before Commissions

Result after Commissions

Stock Price

Result

at April

Before

After

Exoiration

"ommissions

Comnissions

Commissions

$20

($225)

$ 50

($275)

( 200)

( 260)

+ 75

( 75)

100

( 175)

( 125)

100 •

( 225)

466

On July 20 , 1976 a registered representative for a regional
brokerage firm convinced his customer to effect the following vertical
or money spread:*

Buy 3 PRD Oct 30 <§ 8-5/8 $ 2,587.50

Sell 3 PRD Oct 35 @ 4-1/4 -1,275.00

1,312.56

The best possible outcome for the customer after commission was a $4.52
loss while the customer could have lost as much as $1430.68. Figure IV
below depicts the profit-loss potential of this "underwater trade" both
before and after accounting for commissions.

* A vertical spread involves the purchase and sale of options on the
same underlying stock. The options have the same expiration date
but have different strike prices.

46:

Figure III
Date of Transaction: July 20, 1976

Strategy:
Position Assumed:

Cost of transaction:

Best Possible Outcome:
(after commissions)

Maximum loss (Cost of
transaction plus
□emissions)

Money Spread

Buy 3 PRD Oct 30 § 8-5/8
Sell 3 PRD Oct 35 3 4-1/4

$1,312.50

-$4.52

$1430.68

($2,587.50) Cost of Options
( 1,275.00) Proceeds of Options Sale
1,312.50

STXK PRICE AT EXPIRATION
30 35

$300
200
100

Result Before commissions
f '

Profit

100

200

300

400

500

600

700

800

900

1000

1100

1200

1300

1400

1500

Result After Commission

A. Assumes that, prior to exercise,
the calls are liquidated in
closing transactions.

B. Assumes assignment against
short call, purchase and
sale of stock.

Stock Price
at October

Expiration

Result Before
Conr.ission

-1312.50
-1312.50
-1312.50
+187.50
+187.50
+187.50

Result After
Commission
(Assume Liquidation
of Calls)

-1430.68

-4.52

-80.60

-86.58

Result After

Corra.ssi.on
(Assume Short

Call Assignment)

-1430.68

-4.52

-260.10

-285.58

468

b. The use of recommendation lists
Some trades vdiich are uneconomic for customers are derived from the
lists of recommended covered writinq opportunities which many firms dis-
tribute to their salespersons or to customers. Frequently, these recom-
mendation lists show the rate of return on an investment if the call is
exercised, since this assumption will show the best return on investment
possible in a covered writing transaction. In addition, the return figure
qenerallv oresupposes a minimum purchase of at least 300 shares of stock
and the sale of three calls in a customer's margin account. Comparable
returns would not be possible for a smaller trade or for trades effected
in a cash account since the relative commissions would be higher and the
customer's derosit qreater than what they would be in a margin account.
For example, the followinq covered writing recommendations were disseminated
bv a large national firm to its sales staff in May 1976. The firm's
recommendation list included the information in Columns I through IV. Column
V, calculated bv the Ootions Study and based on a purchase of 100 shares
and the writinq of one call, demonstrates the significance that commissions
can have on the small investor and his choice of options strategies.

III

Rate of

return if calls

Ootion

Stock

Option

exercised (300

Series

Price

shares, 3 calls)

CIC Jan 15

14 1/8

13/16

19 %

MOB Nov 60

58 7/8

3 3/4

FCF Oct 15

14 7/8

TR Nov 25

23 7/8

1 5/8

JM Nov 30

29 7/8

2 5/8

EK Jul 110

107 1/8

5 1/8

Rate of

return if

call

exercised

(100

shares, 1

call)

5.7

5.1

7.5

7.2

5.8

469

Oie registered representative testified that he effected for a
customer account an uneconomic trade which he derived from his firm's
national recommendation list. Such a situation is not unlikely since
firms do not always warn users of the lists that the recommended
transactions may be only marginally profitable or even uneconomic at sizes
different from those recommended by the firm.

Another disturbing aspect of some recommendation lists composed by
major brokerage firms is that the recommendations, including those with-
out adeauate warnings, are sometimes made available to registered repre-
sentatives throuah a toll-free telephone number with only an admonition
to emolovees that the telephone number is not to be circulated outside
the firm. Approximately 20 percent of the firms in the industry group
sample use, or have used, an internal phone service to make periodic options
recommendations available to their sales force. Most of these firms have
no effective controls to prevent dissemination of the toll-free numbers
of these ohone services to public investors. As a result, customers
may be able to use the " Dial -An-Opt ion" features directly.

Transactions with little or no profit potential to the customer are
not necessarily effected only by unscrupulous registered representatives.
The Oct ions Study believes that some customers are involved in uneconomic
transactions simbLy because their registered representatives do not understand
the transactions which they are recommending. Table VT below presents
four covered call writing transactions which one registered representative
actually recommended to and executed for his customers:

470

TABLE VI

Security

Braniff

Coastal States
Ballv Mfq.
Inexco

Maximum potential
profit before
commissions

$270
290
217
249

Commissions

$179
202
121
134

Maximum poten-
tial profit after Capital
commissions at risk

$91
88
96

115

$2836
3841
1863
2332

As can be seen, each of these four transactions results in a commission
benefit to the reqistered representative and his brokerage firm which
exceeds the customer's maximum potential profit after commissions. Moreover,
the customer's best outcome (after commissions are deducted) is small,
particularly when comoared to the capital which the customer must place
at risk. These trades are particularly troublesome because they involve
covered writinq, a strategy widely touted as "conservative" by many
reqistered representatives and brokerage firms.

The Options Study noted that those covered writing trades which
proved to be uneconomic to the customer usually involved recommendations
to purchase stock and to write in-the-money calls against it. This
strateqv denies the customer any profit potential from a rise in the
price of the underlying stock, since it effectively limits the potential
profit of the trade to the amount by which the sum of the time premium
and dividends received exceeds the commission charges for the trades.

An example of such a trade was described in a complaint letter
from a customer . This customer , whose investment objective was
capital appreciation, was convinced by a registered representative

471

for a national brokeraqe f irm to buy 200 shares of International Harvester
at 27 3/4 and sell two calls with a strike price of $25 at 3 7/8 each.
The customer's maximum potential profit was $225 (1 1/8 on each of the
two calls written), olus projected dividends, less commissions. Even
if the customer were not assigned an exercise notice prior to the payment
of International Harvester's dividend ($75 on 200 shares), his maximum
profit (including the $75 dividend) would be $78.53 while his brokerage
firm's commission revenue from the same trade would be $221.47. Tne more
likely event, an exercise prior to payment of the dividend, would deprive
the customer of the $75 dividend and result in a maximum profit to the
customer of $3. 53 - a small return when compared to the investment of nearly
$5,000. This transaction is summarized below in Figure V:

FIGURE V

TRANSACTION: Buy 200 Int'l Harvester § 27 3/4

Sell 2 Int'l Harvester APR 25 @ 3 7/8

$5,550 Cost of Stock
( 775) Proceeds from
4,775 Calls

Cost to establish position: $4775.00
Commission: 130.62

Capital at risk: 4905.62

Maximum qain if
calls exercised
before dividend,
commission deducted
( $221 . 47 ) : $3.53

Maximum return
before commission
and dividend: $225

Maximum gain if call
not exercised before
dividend, commission
deducted ($221.47): $78.53

472

5. Conclusions and Recommendations

The Cptions Study has found numerous problems arising from the dual
role of the registered representative as commission salesman and investment
adviser. These problems include not only excessive trading in customer
accounts and uneconomic trades which benefit the salesperson and his firm
more than the customer , but also recommendations for options trading
unsuitable for customers, use of misleading selling documents to induce
customers to trade options and various misrepresentations to customers
about the status of their accounts.

Earlier sections of this chapter set forth recommendations designed
to improve the controls on customer suitability and to prevent the abuses
of the various forms of salesperson/customer communication. Implementation
of these recommendations would help provide the customer with sufficient
information concerning the status of his account, commissions, and other
cherqes, to enable him to monitor the activity in his own account. The
same controls would also help firms and regulators to analyze and control
customer options account activity.

However , additional controls are necessary to insure that the firm
is able adequately to monitor options trading in customer accounts.
Existing compliance systems, which flag accounts by using a single
parameter for commissions and/or number of trades, are not adequate
to meet the needs imposed by options trading. For example, existing
reviews may not identify rapid or large increases in risk in an

473

account or may not detect irregular trading in a small account in
which the activity level fails to exceed an established parameter.

Likewise, a brokerage firm's system that places total reliance on
activity letters to determine whether a customer is aware of the questionable
trading in his account may not alert the firm's supervisors to a problem
account, Unless the customer understands the purpose of the letter, he
may not give it appropriate attention or the salesperson may discourage
him from returning it or otherwise responding to the firm. In addition,
brokerage firms are hesitant to send candid letters to customers since
the questioned trading may be acceptable to the customer.

As long as firms rely on selection criteria which do not
relate the level of account activity to the equity in the account
or to the customer's investment objectives, they will be unable to
oroperly monitor the trading in customer accounts.

Accordinglv, the Options Study recommends:

THE SELF-REGULATORY ORGANIZATIONS SHOULD
ADOPT RULES REQUIRING THAT THE HEADQUARTERS
OFFICE OF EACH BROKER-DEALER ACCEPTING
OPTIONS TRANSACTIONS BY CUSTOMERS BE IN
A POSITION TO REVIEW EACH CUSTOMER'S OPTIONS
ACCOUNT ON A TIMELY BASIS TO DETERMINE:

— COMMISSIONS AS A PERCENTAGE OF THE ACCOUNT EQUITY;

— REALIZED AND UNREALIZED LOSSES IN THE ACCOUNT
AS A PERCENTAGE OF THE CUSTOMER'S EQUITY;

— UNUSUAL CREDIT EXTENSIONS;

— UNUSUAL RISKS OR UNUSUAL TRADING PATTERNS
IN A CUSTOMER'S ACCOUNT.

474

The Options Study found that some of the most serious trading
irreqularities occurred in customer accounts which were handled by a
reqistered representative on a discretionary basis. Since many
of these customers did not understand the risks involved in options
trading, they could not adequately monitor their own accounts. Particularly
vulnerable were customers who entrusted funds to registered representatives
to be manaqed on a discretionary basis according to the terms of options
"programs" which entailed speculative or risky options strategies.
Even the additional customer disclosure information recommended earlier
in this report might not provide sufficient protection for some of these
customers.

Customers who grant discretion over their accounts to a registered
representative depend on that registered representative to make investment
decisions suitable to their investment objectives. Both the Commission
and the courts have held that whenever a customer is dependent upon his
broker, the broker has a special duty not to take advantage of his customer.
49/ This duty has been viewed alternatively as a fiduciary duty 50/ and
as part of the broker's implied representation that he will deal fairly
with his customer. 51/ A violation of this special duty is a violation
of the antifraud provisions of the securities laws.

49/ Pucker & Pucker, 6 SEC 386 (1939); Charles Hughes & Co. v. SEC,
139 F.2d 434 (2d Cir . 1943), cert, denied, 34 U.S. 786 (1944).

50/ G. Alex Hope, 7 SEC 1082, 1083 (1940); Barthe v. Rizzo,
384 F. Supp. 1063 (S.D.N.Y. 1974).

51/ Charles Hughes & Co. v. SEC, supra note 49.

475

In addition, registered representatives who exercise discretion
over securities accounts of customers are subject to the traditional
reouirenents imposed by state law on those who manage the money
of others, including, unless otherwise agreed, a duty to preserve the
beneficiary's capital and to avoid speculation. 52/

The Options Study believes that any registered representative (or
firm) who proposes to exercise discretion over an account trading options
should, as a part of the obligation to deal fairly with the customer,
disclose to the customer the nature and risks of any proposed trading
program or strategy which is not designed specifically to preserve
caoital or which involves speculation. For this disclosure to be
effective, the customer must understand it. Accordingly, the Options
Study believes that, before a customer is allowed to participate in
any discretionary options trading program, the firm and the registered
representative should have reasonable grounds to believe that the
customer is able to bear financially the risks of the proposed trading
trogram and also to understand the nature of the risks involved.

Accordingly, the Options Study recommends:

( 1 ) THE SELF -REGULATORY ORGANIZATIONS SHOULD AMEND
THEIR RULES TO REQUIRE THAT EACH OPTIONS CUSTOMER IN WHOSE
ACCOUNT DISCRETION IS TO BE EXERCISED IS PROVIDED WITH A
DETAILED WRITTEN EXPLANATION OF THE NATURE AND RISKS OF THE
PROGRAM AND STRATEGIES TO BE EMPLOYED IN HIS ACCOUNT; AND

52/ Restatement (Second) of Agency § 425 (1958).

476

(2) THAT THE SROP OF EACH BROKERAGE FIRM PERSONALLY
MAKE A DETERMINATION IN EACH CASE THAT THE DISCRETIONARY
CUSTOMER UNDERSTANDS AND CAN BEAR THE RISKS OF THE OPTIONS
TRADING PROGRAM OR STRATEGIES FOR WHICH IT IS PROPOSED THAT
HE GRANT INVESTMENT DISCRETION TO THE FIRM OR ANY OF ITS
EMPLOYEES; AND THAT THE SROP MAKE AND MAINTAIN A RECORD OF
THE BASIS FOR THAT DETERMINATION.

477

I. EXERCISE PROBLEMS

1. Introduction

Before the availability of listed options, each put and call
options constituted a contract directly between two identifiable
parties, the holder (buyer) and the writer (seller). When the
option holder exercised his option, the contract obligated the
call writer to sell the underlying security to the option holder,
or the put writer to purchase the underlying security from the
option holder .

The introduction of listed options issued by the OCC, however,
has severed the contractual obligations between writer and holder.
In the event of exercise, the holder of a listed option looks to the
OCC, rather than to a specific writer, for delivery or purchase
of the underlying stock; the OCC, in turn, demands performance
from an option writer who is contractually obligated to the OCC
throuqh a broker-dealer firm.

The specific writer to be exercised is selected through an
allocation process. First, the OCC assigns an exercise notice
to a selected broker-dealer firm which has sold, either for its
own account or for a customer account, an option in the same series
as the exercised option. Next, if the assignment is for a customer
account, the brokerage firm re-allocates the exercise notice to
one or more of its public customers according to a plan filed
with and approved by the options exchanges.

40-940 O - 79 - 33

478

When a customer who has written an option is assigned an exercise
notice, he no longer can liquidate his position in the options market
but must fulfill the terms of his obligation. Whether the position was
uncovered or covered, he will incur commission costs.

Although the integrity of this allocation system is vital to the
maintenance of investor confidence in the fairness of the options
markets, the following example indicates that several weaknesses
exist in the present exercise system.

In a series of trades executed in early March 1977, floor
brokers for a national brokerage firm purchased enough Coca Cola
May 70 calls on the American Stock Exchange to close out an existing
ten contract short position in the firm's proprietary account.
By mistake, however, the brokers marked the order tickets as opening
rather than closing purchase transactions. As a result of this
mismarking, the records of the OCC showed that the firm's account
maintained a ten contract long and a ten contract short position in
the Coca Cola May 70' s, while the firm's record showed a flat position
in these options.

On March 2, 1977, Coca Cola declared a dividend of $.77 per share
payable to holders of record on March 16, 1977. In an attempt to capture
this dividend, certain holders of the May 70 Coca Cola call options
exercised their options about two months before expiration. On March 10,
1977, the ex-dividend date, the OCC assigned to the same national brokerage
firm's proprietary account an exercise notice for the 10 Coca Cola May

479

70 call options contracts reflected in the OCC records. Although this
exercise notice was clearly directed to the firm's proprietary account,
the firm's employees "re-allocated" the exercise assignment to the accounts
of several unsuspecting public customers. Had the firm delivered its
own Coca Cola stock to meet this exercise notice, it would have been
forced to forego the $770 dividend on the 1,000 Coca Cola shares
delivered .

Later that day, the brokerage firm employees discovered that
two of the public customer accounts to which they had "misallocated"
these exercise notices had already been transferred to another brokerage
firm. With the cooperation of the new brokerage firm, these employees
were able, in effect, to oass along the exercise assignment notices
to the already transferred customer accounts.

The unsusDecting customers delivered the Coca Cola stock as required,
lost the dividend on that stock, and paid aggregate commissions of $719.50
for the exercise transaction. The brokerage firm, on the other hand,
received a $770 dividend on the 1,000 Coca Cola shares it should have
delivered from its own account in response to the exercise notice.

This misconduct was discovered by one of the exchanges only by
accident and not through any organized examination or investigation
process. 53/ None of the public customers who had been assigned
exercise notices ever learned that he had borne the burden of a

53/ This matter was initially discovered when two exchange employees
overheard a conversation among strangers on the New York subway.

480

misallocation. Despite exchange rules that provide public access
to exercise allocation plans devised by broker-dealer firms, customers
generally have little chance to detect shortcomings in the design or
irregularities in the operation of such plans.

Proper prevention and detection of abuses such as the one described
above require:

(1) an exercise allocation method fair to the public customer; and

(2) adequate documentation and supervisory controls to
assure that these allocation procedures are being
followed consistently.

2. Allocation Plans

Exchange rules require each member firm to file with the various
options exchanges its plan for allocating exercise notices to its
customers and to make these plans available for review by customers.
Despite the straightforward requirements imposed by these exchange rules,
brokerage firms sometimes circumvent or ignore the requirements. Conse-
ouently, both the AMEX and CBOE have had to caution numerous firms for
failure to submit their plans for approval or for failure to follow
their declared allocation procedures once approved.

Among the allocation methods approved by the exchanges are a random
selection basis, a " first-in, first -out" basis, variations of these method;
to distinguish between "block-size" orders and individual orders, and
other methods deemed fair and equitable to the member firm's customers.
Of the industry group sample, 62 percent used variations of the

481

random selection allocation methods; 36 percent used " first-in, first -out"
allocation methods; and 2 percent of the industry sample used other methods,
There seems to be a trend throuqhout the industry toward random
selection and away from "first-in, first -out" allocation methods. Each
method has advantaqes and certain regulatory problems arise from each,
a. Random selection methods

Althouqh the sophisticated samplinq techniques of certain random
basis allocation systems provide a high degree of objectivity, the
complexity and lack of uniformity of such methods can impede firms and
regulators in conductinq prompt and effective audits. Reconstructing
how exercise notices were allocated during even one expiration period
is sometimes difficult.

Of qreater concern to the Options Study, however , are the informal
random basis allocation systems. A senior officer of one firm, for
instance, described his firm's allocation method as the "flip of the
coin" method. The employees of another firm explained how that firm
used "a random draw" allocation method as follows: they created "named
sliDs" for each short contract in a given customer's option position,
rooled those slips, and then engaged in a drawing to determine the
allocation of exercise notices.

The most prominent weakness of these informal exercise allocation
svstems is the absence of workpapers or other documentation to verify
that the allocation process was accomplished in a manner fair and equitable
to Dublic customers. In addition, in several cases, brokerage firms had

482

no supervisory procedures which described even the informal procedures
that the firm purported to follow. These circumstances provide little
assurance that allocation methods will be consistently or equitably
applied from one expiration date to the next.

b. "First-In, First-Out" (FiFo) systems
In a FiFo allocation system, the first customer to be assigned
an exercise notice in an options series is the customer who first
wrote a still-open contract in that options series. Although straight-
forward FiFo systems are easily understandable and verifiable by audit,
FiFo systems generally work to the disadvantage of longer term options
investors who are more likely to be exercised than customers with
more recently established positions.

In addition, some brokerage firms use variations of the FiFo allocation
system which favor the active or large account or which are otherwise
inconsistent with exchange requirements that such systems be "fair and
eaui table" to customers. Both the CBOE and the AMEX repeatedly have
cautioned firms against the use of FiFo systems which do not assure
that the customer who first writes an option will be assigned an exercise
first reaardless of other subsequent activity in the account. Nevertheless,
several firms still use modified FiFo systems which provide that any
activity in an account subsequent to the trade date automatically updates
that account's "first- in" date to the date of the most recent activity.

483

Such a modification reduces the risk that exercise will fall upon the

more active and larqer account while increasing the risk of exercise

for the smaller or less active account.

Exercise allocation methods must be fair and equitable to

the public customer. Accordingly, the Options Study recommends:

THE SELF-REGULATORY ORGANIZATIONS SHOULD
AMEND THEIR RULES TO REQUIRE MEMBER FIRMS
TO PROMPTLY ADOPT A UNIFORM METHOD FOR
THE RANDOM ALLOCATION OF EXERCISE NOTICES
AMONG CUSTOMER ACCOUNTS.

3. Audit Trails

The most pervasive weakness in the process of allocating exercise
notices is the lack of an audit trail, that is, of workpapers, records,
or other documentation which enable supervisors and regulators to verify
that an approved exercise allocation plan has been followed. Since
certain firms do not maintain adequate documentation to explain
the operation of their allocation methods, some supervisors express
confusion about the exercise allocation procedures they are supposed
to control. Other firms have no records to verify that the procedures
they purport to use have, in fact, been applied.

The experience of one large regional brokerage firm demonstrates
many of the weaknesses associated with this lack of an audit trail
for exercises allocations. Although the compliance officer of the firm
told both NASD and Commission inspectors that the firm used a FiFo method
of exercise allocation, analysis of customer accounts which had been

484

assigned exercise notices during several expiration periods disclosed
numerous deoartures from any known FiFb method of allocation.

In the ensuing investigation, employees of the firm gave con-
flicting testimony about the procedures followed by the firm in
allocating exercise notices among customers. Both the firm's president
and compliance officer testified that they believed the firm employed
a FiFo system. The margin clerk, however, testified that his supervisors
had instructed him to employ the FiFo system unless an assignment would
affect one of the customers of the firm's head options trader. In
that case, he was to inform the head options trader of the customer
accounts having positions which could be exercised, after which he
would receive a list of customer accounts designated to receive exercise
notices. The margin clerk testified about the problems that arose
when he initially attempted to use the FiFo method:

After I notified [the head trader] of the
assignments, I proceeded to work on that
method by assigning the customers the
options that were first in. And apparently
[the head trader] did not like the assignments
as I related them to him, and spoke to
[the sales manager] who in turn called
my boss, who was operations manager, and
I was told by my boss to go along with
whatever assignments they wanted.

The firm's options trader insisted that he merely served as a

conduit for information between the margin clerk and the sales manager

of the firm. In contrast, the sales manager testified that he personally

allocated all exercise assignments on a random basis, using an

485

undocumented lottery method in which he blindly selected slips of
paper reDresenting customer positions. An analysis of customer options
accounts, however, revealed that certain customers consistently sustained
large losses from untimely exercises while other customers consistently
avoided exercise. Most of the accounts assigned exercise notices were
those of long time customers with large account equity who could bear
the losses resulting from exercise better than smaller accounts serviced
by younger salesmen .

Accordingly, the Options Study recommends:

THE SELF-REGULATORY ORGANIZATIONS SHOULD
REQUIRE MEMBER FIRMS TO KEEP SUFFICIENT
SPECIFIC WORKPAPERS AND OTHER DOCUMENTATION
RELATING TO ALLOCATIONS IN PROPER ORDER
SO THAT A FIFM'S COMPLIANCE WITH THE UNIFOPM
EXERCISE ALLOCATION SYSTEM CAN BE VERIFIED
PROMPTLY FOR AN APPROPRIATE PERIOD OF
TIME.

CHAPTER VI
SELF-REGULATORY ORGANIZATION OVERSIGHT
OF RETAIL FIRMS AND THEIR ASSOCIATED PERSONS
I. INTRODUCTION

The self -regulatory organizations ("SROs" ) are required by law to
oversee the conduct of their member broker-dealer firms and to impose
sanctions on those firms and their associated persons when violations
of the law or SRO rules are detected. This chapter primarily addresses
SRO efforts to enforce member firm compliance with rules which relate
to retail sales practices. Certain other SRO activities pertaining to
the oversight of broker-dealer firms, such as the registration of sales-
persons and the monitoring of financial and operational developments,
are also discussed.

The Commission's release announcing the commencement of the Options
Study noted the Commission's concern that lapses in "regulatory programs
by options exchanges to detect and deter [selling] practices [abuses] are
more serious than the Commission had earlier perceived" 1 /, and
directed the Options Study to review, among other things, "the ability
of self -regulatory organizations to enforce compliance by brokers and
dealers with appropriate selling practices [rules] regarding standardized
options." 2 /

As a first step in analyzing the effectiveness of SRO sales practice
compliance programs, the Options Study asked each options exchange to

!_/ Exchange Act Release No. 14056, p. 25 (October 17, 1977).
2_/ Id. at 27.

(487)

488

submit a detailed description of its compliance program. 3 / Similar
requests were made of the NYSE and NASD. 4 / After analyzing these
submissions, the Options Study conducted on-site inspections of
the AMEX, CBOE, NYSE, PHLX and PSE to obtain a better understanding
of their compliance programs and to determine the manner in which
each SRO followed the procedures that it had described in response
to the Options Study's request. 5 / During these on-site inspections,
the Options Study reviewed SRO compliance files and interviewed
selected SRO compliance personnel. Cumulatively, the Options Study
reviewed approximately 1,200 routine options examinations which had
been conducted by the exchanges and approximately 300 options related
cause examinations and related disciplinary actions. 6_/ In addition,
approximately 75 interviews were conducted with SRO compliance personnel.

3 / Appendix A.

4 / Appendices B and C.

5 / This chapter does not include compliance programs of the MSE or NASD,

unless otherwise noted. The MSE's submission to the Options Study
was submitted in a form that was not usable. Despite the Options
Study's requests to remedy that problem, the MSE did not do so. The
NASD's submission arrived too late to be included in all phases of
the Options Study's analyses.

6 / For a description of routine and cause examinations, see pp. 11-14,

infra.

489

The Captions Study found serious shortcomings in tne SROs' selling
practice compliance programs. While the severity of the problems
varied among the SROs, the Options Study identified several deficiencies
which are common to the programs of all SROs. In summary, these

are:

(1) SROs in their compliance activities fail to collect and use
available information, in that -

- the SROs frequently fail to seek out and question
public customers when inquiries of such customers
might be useful in their examinations and investi-
gations of member firms and their salespersons

- the SROs generally do not share among themselves their own
compliance data

- the SROs do not attempt to obtain useful compliance infor-
mation which is available from government agencies

- the SROs do not make adequate use of information available
at member firms

(2) SRO procedures for examining and investigating their members
are deficient, in that -

- examinations find procedural and record-keeping pro-
blems but are not adequately designed to find sub-
stantive violations such as fraud, excessive trading,
and unsuitable recommendations

- investigations too often focus narrowly on a specific
episode or problem and fail to ascertain whether the
specific matter is part of a broader pattern of abuse

(3) SRO disciplinary proceedings often are ineffective to deter
future violations in that SROs frequently -

- use informal sanctions for serious violations

- allow repeated violations to continue without deci-
sive remedial action.

In describing these problems in the following section of this

chapter, illustrative cases are provided. It might be useful at this

490

point, however, to mention one firm's compliance history since 1973
(summarized in Appendix D) which seems to illustrate a number of
these problems.

In the course of their 32 options related examinations and
investigations of this firm during this period, the AMEX, CBOE, NASD
and NYSE did not collect and evaluate available compliance data
(including, information about examinations and investigations con-
ducted by each other), did not conduct sufficiently thorough inquiries,
did not coordinate their compliance efforts, and failed to detect
apparently serious selling practice abuses in this firm. Moreover,
even when violations were noted, the disciplinary action taken by
the SROs was ineffective in motivating the firm to cease its improper
practices and initiate effective remedial action because, as shown in
Appendix D, the firm continued to violate the same or related SRO
rules. The Commission's staff undertook an inquiry of this firm
in 1977, and found apparently serious violations of the antifraud
provisions of the federal securities laws and failures by the firm
to supervise adequately certain salesmen.

During the Options Study's interviews, SRO officials have offered
two explanations for these systemic deficiencies. First, these officials
acknowledge that, because of their preoccupation with the problems
which emerged from the establishment and rapid expansion of the
new options markets, the exchanges did not devote adequate attention

491

to selling practice compliance activities. Second, the SROs generally
concede that they concentrated on their individual self-regulatory
obligations without recognizing the regulatory needs of other SROs
and the importance of other SROs' regulatory efforts to their own.

To remedy these deficiencies the Options Study's principal
recommendations are that tne SROs: (1) broaden the scope of their
investigations and examinations and routinely question public
customers when necessary to determine whether there may have been
a violation of the federal securities laws or SRO rules, to resolve
disputed issues of fact, or to verify information obtained from
another source; (2) develop ways to better share information and
allocate responsibility, including the establishment of a central
repository of information concerning common member firms and their
employees; (3) establish industry-wide minimum standards and procedures
for conducting their compliance programs; (4) restrict informal disci-
plinary actions to cases in which public customers have not been injured
and in which rule violations are minor or isolated; and (5) amend their
rules (if necessary) to permit restitution to be awarded to injured
investors as a remedial sanction in appropriate enforcement cases.

Many of the Options Study's concerns were brought to the attention
of the SROs at a meeting held with the members of the Options Study
staff in August, 1978. 7_/ Thereafter, the SROs in a series of meetings;

7 / See Chapter TV.

492

informally referred to as the Self -Regulatory Conference, 8 / agreed,
among other things, "to review current industry compliance practices
toward the goal of developing a more standardized compliance program"
and "to review the feasibility and usefulness of creating a central
repository for compliance information." The Options Study believes that
the proposals under study by the SROs are a good first step in developing
solutions to remedy many of the problems identified in this chapter.
II. AN OVERVIEW OF SRO COMPLIANCE PROGRAMS

Before reviewing the problems in SRO sales-practice compliance
programs, it is useful to have an overview of such programs. While each
SRO's program has certain unique features, there are some features which
are common to all. SROs have monitoring programs, conduct cause examina-
tions and routine examinations, and have procedures for imposing
disciplinary and other remedial sanctions. 9 /

A. Monitoring programs

There are five monitoring programs which have relevance to member
firm oversight: (1) regulation of the employment and termination
of employment of registered representatives; (2) review of customer
complaints; (3) review of member firm advertising; (4) oversight of

8_/ See Chapter IV.

9 / In sane instances, however, SROs have allocated responsibility among
themselves for the administration of certain programs. See pp. 30-32,
infra .

493

the financial and operational condition of retail firms; and (5) control
of extensions of credit to public customers.

1. Employment and termination of registered representatives:
The SROs are required to prevent their members from employing, without appro-
priate authorization, individuals who have been prohibited from selling secu-
rities because they have been found to have violated the federal secu-
rities laws or certain other statutes or rules as specified in the
Exchange Act 10/, or who are subject to a "statutory disqualification" as
defined in the Exchange Act. 11/ In addition, each SRO has specified
qualification standards for registered representatives which include the
passing of certain qualification examinations. 12/ As an initial step in
the qualifying process, an applicant must apply for registration with the
SROs to which his prospective employer belongs. The standard application
form used by the SROs requires the applicant to respond to questions about
his background and employment history, and to state whether he is currently
the subject of any investigation by an SRO, the Commission, or other securities
regulatory bodies. Through this registration process, SROs should be able
to identify those individuals who may require special supervision by the
employing firm, or who should be excluded from the securities. business.

10/ See Section 15(b)(4), 15 U.S. C. 78o(b)(4).

11/ See Section 3(a) (39), Exchange Act, 15 U.S.C. 78c(a)(39); see also

Sections 6, 15(b) and 15A of the Exchange Act, 15 U.S.C. 78f, 78o(b),
and 78o-3.

12/ For a discussion of these examinations, see Chapter V.

40-940 O - 79 - 34

494

When a salesperson leaves a firm, the firm is required to notify
each SRD of which it is a member so that the salesperson's registration
with the SRD may be cancelled. SROs require these termination notices
to specify the circumstances of termination, including whether the
salesperson was fired because he violated a provision of the securities
laws or an SRD rule, is or has been the subject of a customer complaint,
or has been named as a defendant in a civil action for alleged violations
of the securities laws. The SRD compliance staffs believe that termination
notices aid significantly in detecting potential problems.

2. Customer complaints; Some securities customers complain
directly to the SRDs about problems they have experienced as well as to
the brokerage firm and the Commission. During 1977, the options exchanges
and the NASD received approximately 750 customer complaints, of which
approximately 150 involved options related selling practice problems.
Only the NYSE requires its members to forward to it a copy of all "major
complaints" the members receive. 13/ SRDs have procedures to review
customer complaints which they receive directly or by referral from
other SROs or the Commission. In addition, most SRD examinations include
a review of the firm's complaint files or customer correspondence files.

3. Advertising; Tne SRDs have adopted standards governing
their members' advertising with respect to options. To help ensure that
misleading options related advertising is not used in violation of these

13/ NYSE Rule 351(c). For a discussion of this reporting requirement ,
see pp 38 - 40, infra.

495

standards, tne options excnanyes require their members to submit
options related advertising to them for review and approval prior to
use. 14/ borne bROs relieve their members of tne obligation to submit
options advertising tor clearance prior to release if the advertising
nas oeen approved d/ anotner bRU. 15/ In addition, there are informal
agreements oetween or among bROs oy which one bRO may review advertising
on oenait ot otner bROs.

Utner sales literature, such as marxet letters that contain analyses,
reports, recommendations, or comments on options, is not required to be
tiled with an bRO prior to distrioution. All bRO procedures call for
a review ot Doth options advertising and options sales literature as
part ot tneir routine examinations of member firms. The CBOE is the
only bHJ, nowever, whicn reviews sales literature throughout the year
even wnen tnere is no routine examination, Each week the CBOE staff

14/ bee also Chapter V. The amEX, CBOE, MSE and PHLX have filed with
tne Commission proposed rule changes which, if approved, would
estaoiisn uniiorm standards for the review of options sales
literature, bee bR-AMEX-1978-21, 43 Fed. Reg. 50512 (Oct. 30,
1978); bK-CbOE-1978-26, 43 Fed. Reg. 50515 (Oct. 30, 1978); bR-
NbE-1979-1 (unpublisned); bR-PHLX-1978-21, 43 Fed. Reg. 52795
(Nov. 14, 1978). The Commission's staff has been informed that
tne PbE intends to suomit similar proposed rule changes, but
as ot January 20, 1979, such proposals have not oeen filed with
tne Commission.

15/ Tne NAbU requires that member firms file proposed options advertising
with tne Association. Unless tne NAbD staff objects to the proposed
advertising witnin 10 days, the firm may release it. At the NYbE,
member firms are not required to obtain NYbE approval before issuing
advertising, althougn NYbE firms are required to adhere to certain
NYbE advertising standards.

496

selects several firms and requires those firms to submit all of their
options sales literature for a particular month for review by the staff;
each CBOE firm is selected for review twice a year.

4. Financial responsibility early warning systems; To
assure that retail firms are in compliance with applicable net
capital, margin and similar requirements, every firm is required to
make confidential periodic filings with an SRO disclosing information
on its financial condition and significant operational developments.
To avoid unnecessary duplication, the Commission has allocated re-
sponsibility for reviewing these filings among the SROs, and requires a
firm to file its financial reports only with the designated SRO. In
addition, a firm is required promptly to notify the Commission and the
designated SRO whenever its financial condition reaches certain pre-
scribed levels or its operational responsibilities are impaired. 16/

At least once a year, the designated SRO makes an in-depth ex-
amination of each retail firm's financial and operational condition.

5. Credit monitoring; Federal law requires purchasers of
securities to pay for their cash purchases within a specified time period,
but permits retail firms to apply for and receive on behalf of a customer
fran an SRO an extension of the payment date for "exceptional circum-
stances". Applications for extensions of time ("Regulation T

16/ See 17 CFR 240, 17a-ll; See also Chapter VII.

497

requests") may be filed with an appropriate SRO. SROs prefer, however/
that applications be filed with the SRQ which has been designated to
process the firm's financial reports.

Each SRO has its own system for processing Regulation T requests.
All SROs, except the NYSE, process complaints manually. The NYSE, which
receives about 450,000 requests per year (more than any other SRO), uses
a computer to process and, in most instances, grant automatically
extension requests.

B. Cause examinations

Cause examinations, generally, include examinations, inquiries
and investigations into problems identified in the monitoring programs,
described above, which the SRO believes warrant immediate or special
attention. Most cause examinations consist of a written or oral request
made to the firm by an SRO for information, statistics, or related
data pertaining to a specific problem. Upon receipt of the response,
the SRO staff decides whether the federal securities laws, Commission
rules, or an SRO rule may have been violated and, if so, whether
disciplinary action seems necessary. The SRO conducting a cause
examination does not always visit the firm, take testimony from
witnesses or the subjects of the investigation, or inquire whether
other SROs are engaged in or have recently completed a similar inquiry.
During 1977, the options exchanges, the NASD and the NYSE conducted
approximately 300 cause examinations into potential options related
problems.

498

C. Routine examinations

There are two types of routine examinations: (1) capital examin-
ations, which focus principally on the financial and operational condition
of a firm; and (2) sales practice examinations, which review the sales
practices of a firm. Sales practice examinations may be product oriented
— for example, a review of how a firm sells options -or may include,
as in the case of the NYSE, a review of the firm's entire securities re-
tailing effort.

In general, capital examinations are designed to determine whether
the firm is in compliance with the net capital, books and records, and
related customer protection rules.

Sales practice examinations, on the other hand, are intended to
detect selling practice abuses. These examinations normally are pre-
ceded by a review of the files of the examining SRO which relate to the
firm, including the report of the preceding SRO sales practice examin-
ation. 17/ The examinations usually include interviews with representa-
tives of the firm, examination of the firm's advertising and correspon-
dence files, its exercise allocation and account opening procedures, and
a review of customer accounts to determine whether requisite account
opening forms, agreements and approvals are on file and whether there are
violations of the applicable suitability standards. 18/

17/ In some instances, where the preceding examination of the particular
firm was conducted by another SRO, the report is not made available
to the examining SRO. See pp. 21-30, infra.

18/ See Chapter V.

499

Some SROs report the findings of the examination by letter to the
firm, and some do so orally. 19/ Each SKO requires its staff to prepare an
examination report either in narrative form (NYSE), in the form of a
fill in-the-blank checklist (AMEX, PHLX, and PSE) which also serves as the
examiners* instructions for the conduct of the examination, or both (CBOE).

During the period 1973-1977, there were a total of 3,017 options-
related sales practice and combined capital/sales practice examinations.
Of these, 1577, or 52 percent, were conducted by the NYSE. Among the op-
tions exchanges, the AMEX conducted the most sales practice examinations,
691, which accounted for about 23 percent of all such examinations.

19/ When the results of an examination are reported orally to the firm,
the examining SRO normally transmits some sort of written summary
of its findings or acknowledgment to the firm. Such transmittal,
however, may not reflect all of the violations found by the
examination. See n. 26, infra.

500

TABLE I

Number of Cations Related Sales

Practice

(or

Capital/Sales Practice]

i Examinations

Conducted

by SROs

Total

SRO

1973 1974

1975

1976*

1977*

by SRO

NYSE

359 287

311

310

1,577

CBOE

58** 119

121

449

AMEX

146**

329

216

691

PHLX

25**

173

PSE

26**

MSE

88**

Total 417 406 603 824 767 3,017

Note: Figures include some duplication in sales practice examina-
tions of some firms.

The NASD also conducted sales practice examinations, some portion
of which evaluated options trading, but not to the same degree
as those of other SROs. Accordingly, the NASD was not requested to
provide statistics as to all NASD examinations which included a
review of options related sales practices.

The addition of the PSE, PHLX and MSE as options exchanges and as-
sumption by those exchanges of sales practice examination responsi-
bilities for certain of their members reduced the examination responsi-
bilities of the CBOE and AMEX.

The number of AMEX options sales practice examinations in 1976 in-
creased from the preceding year because of the AMEX's inability to
complete all of the sales practice examinations scheduled for 1975,
which resulted in a carryover of the 1975 cycle into early 1976.
See p. 63, below. In 1977, when the AMEX met its cycle, the number
of sales practice examinations conducted by the AMEX declined.

** First year that SRO traded listed options,

501

D. Disciplinary proceedings

Each SRO has procedures to impose disciplinary sanctions or to
seek other necessary remedial action based upon violations uncovered
in the above programs. Disciplinary action may be either formal or in-
formal. In formal disciplinary proceedings, written allegations of
misconduct are served on the respondent, who is given an opportunity to
appear at a hearing and defend against the charges. Then, if the secu-
rities laws, Commission rules, or an SRO rule is found to have been
violated, the SRO may impose a remedial sanction including fines,
suspension, or expulsion from membership and a bar from associating
with any member. 20/ The result of every formal proceeding must be
reported to the Commission and, upon receipt by the Commission, is
available publicly. 21/ Respondents may appeal the final decision to
the Commission, which may affirm, dismiss, remand for further hearing,
or reduce the sanction. 22/ The Commission does not have the authority
to increase the sanction imposed by an SRO. 23/ Any person aggrieved

20/ See Sections 6(b)(6), 15A(b)(7) and 19(g)(1), Exchange Act, 15
U.S.C. 78f(b)(6), 78o3(b)(7), 78s(g)(l).

21/ Securities Exchange Act Rel. No. 34-13726, 42 Fed. Reg. 36415
(Jul. 14, 1977).

22/ Section 19(e), 15 U.S.C. 78s(e).

23/ The Commission, of course, may bring its own civil action or admini-
strative proceeding if it determines that Federal securities laws have
been violated, or that the SRO has not enforced adequately its own
rule. See Sections 15(b) and 21 of the Exchange Act, 15 U.S.C. §§ 78o
(b) and 78u.

502

by the Commission's final order may petition a United States Court of
Appeals for a review of that order.

Informal disciplinary actions primarily take the form of letters
of caution, oral warnings or admonitions, or interviews with the senior
management of a firm conducted by the compliance staffs of the SROs. In-
formal actions do not involve strict procedures such as notice, hearing
and right of appeal. Further, such proceedings do not result in an adjudi-
cated finding of a violation of the federal securities laws, Commission
rules or an SRO rule. Informal disciplinary actions are not filed with
the Commission or made public.
III. OBTAINING COMPLIANCE INFORMATION

For SRO compliance programs to operate effectively, SROs must have
adequate information about the activities of member firms. There are
four primary sources of such information: public customers; the SROs
tnemselves; governmental agencies, such as the Commission; and member
firms. The Options Study found that the SROs often fail to obtain
the full range of relevant compliance data available from these sources.
A. Public customers

Public customers have important, perhaps indispensable, compliance
information for SROs. Customers, for example, know their investment
objectives, the circumstances surrounding the opening of an account
including any representations made by the registered representative,
and the history of their dealings with the firm. 24/ Unless a customer

24/ For a discussion of the importance of customer complaints as
investigatory leads, see Report of Special Study of the Secu-
rities Markets, H.R. Doc. 95, Pt. I, 88th Cong, 1st Sess.,
pp. 269-272 (1963) (hereinafter "Special Study Report").

503

complains directly to an SRO, however, SRO enforcement personnel very
rarely communicate with investors. Most SROs have a general policy
that a customer will not be contacted without prior permission from
the firm. One exchange senior staff member referred to this restriction
as the "unspoken rule." On the other hand, a senior staff official
of the NYSE has recently advised the Options Study that the exchange's
examiners are now contacting customers of NYSE member firms when there
is cause to do so.

Where SRO staffs do not contact customers they do not have ready access
to a very important source of regulatory information which has resulted
in less effective sales practice examinations and cause examinations. In
conversations with the Options Study, SRO staff members attribute their
reluctance to contact public customers to a number of reasons. First,
SRO staff members are concerned about maintaining good relationships
with member firms. They fear that such contacts might encourage customer
complaints against a member firm, or could result in a member firm's
losing a customer's account, or being subjected to litigation. They
are also concerned that, in the event a customer does leave the firm
or sue a member following an interview with an SRO staff member, the
SRO may be sued by the firm for tortious interference with the business
or contractual relationship between the member and its client.

The Options Study identified numerous SRO routine and cause examin-
ations involving customer accounts in which issues of fact relating to
possible violations were left unresolved or were resolved informally in

504

favor of a firm or salesperson without the SRO contacting the firm's custo-
mers. In some instances, the Options Study discovered that, had the SRD
contacted the customer, the customer could have provided information
which would have been relevant in resolving those issues of fact.

Illustrative of such a case was an SRO's investigation of a customer
complaint received by the SRO against a large retail firm. The customer
complained that he had not been advised of the risks of options trading,
had not executed a customer account agreement and that unsuitable trades
had been made in his account. The SRO's investigative report concluded
that "documentation supplied by the firm substantiates the complainant's
contention that the firm did not obtain signed options or customer
agreements until well after the initial options transactions . . . ."
The report also noted, however, that no determination of unsuitability
could be made because "no written investment objective was provided"
by the customer when the account was opened. The matter was closed
without the SRO's interviewing the customer to determine, among other
things, whether the firm had inquired as to his "investment objective,"
or executed transactions which were inconsistent with that objective and
without the SRO even cautioning the firm for the established violation
of permitting the customer to trade options before his account was properly
approved.

505

In another case, an SRO conducted an investigation of apparent ex-
cessive trading in the account of a school teacher. Although the
level of trading in the account was extraordinary, the SRO deter-
mined not to take disciplinary action. In reaching this decision, the
SRO dismissed allegations that the trading had been induced by the mis-
leading statements of the registered representative, noting simply that
the teacher had been advised of the activity in the account. The Commis-
sion's staff, on the other hand, contacted other customers of this
registered representative and learned of similar complaints from at
least eleven other customers. The Commission's investigation is still
pending.

Some SROs also consider only written submissions to be "complaints."
Oral grievances, conveyed in person or over the telephone, to these SROs
are usually classified as "inquiries" and, until reduced to writing,
are not investigated or taken into consideration by SROs in their conduct
of an examination. At one SRO, a senior staff member told the Options
Study, for example, that an investor made a personal visit to the SRO
and complained that his account had been mishandled. The customer was
requested to make a written complaint. When the SRO did not receive
one, no action was taken even though the staff member said that he knew
the salesman involved had been the subject of prior customer complaints.
The staff member also admitted that he did not take any notes of the

506

visit and did not even refer the matter to the SRO's examiners for
possible use in the next examination of the firm.

The Options Study believes that the failure of an SRO to contact public
customers to ascertain facts necessary to determine whether there may have
been a violation of the federal securities laws or SRO rules, to resolve
disputed issues of fact, or to verify information obtained from other
sources and to follow-up on oral complaints are major flaws in the SRO's
compliance programs. The Options Study has voiced its concern to the SROs,
individually and collectively, but they have not as yet abandoned their
respective internal policies which inhibit or restrict communications with
public customers. They have agreed, however, to study the issue and to deter-
mine if there are any "legal impediments" to such conmunications. The Options
Study concurs with the recommendations made by the Special Study of the
Securities Markets in 1963 that, in order to enforce their rules effectively,
SROs should contact public customers. 25/ Accordingly, the Options Study
recommends :

SROs SHOULD INTERVIEW PUBLIC CUSTOMERS, IN
APPROPRIATE CASES, AS PART OF ROUTINE OR
CAUSE SALES PRACTICE EXAMINATIONS TO RESOLVE
FACTUAL DISPUTES AND TO ASCERTAIN FACTS NECESSARY
TO DETERMINE WHETHER THERE HAS BEEN A PROBABLE
VIOLATION OF AN SRO RULE OR FEDERAL LAW.

SROs SHOULD MAKE AND RETAIN WRITTEN RECORDS OF
ORAL COMPLAINTS, EVALUATE THEM CAREFULLY, AND,
WHERE APPROPRIATE, CONDUCT A CAUSE EXAMINATION
INTO THEM AND TAKE THEM INK) CONSIDERATION IN
PLANNING ROUTINE AND CAUSE EXAMINATIONS.

25/ See Special Study Report, Pt. I, p. 328.

507

B. SROs

1. Sharing of information: Each SRO maintains substantial infor-
mation about its members and their associated persons. This information
includes: (1) records of routine and cause examinations, and disciplinary
actions; (2) financial and operational filings made by firms for which the
SRO is the desiqnated examininq authority; (3) customer complaints; (4)
registration files for the firm and its associated persons; and (5) cor-
respondence between the SRO and member firms.

Much of this data could be useful to other SROs, but is not shared
on a routine basis amonq the SROs. Fbr example, SROs do not share infor-
nation about routine sales practice examinations. 26/ Between 1973 and
1977, the NYSE conducted approximately 1,500 options related sales practice
or caDital/sales oractice examinations, but did not disclose routinely
the results of these examinations to the options exchanges, as they
oertained to firms which were common members. The options exchanges
also conducted about 1,500 sales practice examinations, about 75% of
which involved retail firms that were members of the NYSE and the NASD,
but did not disclose routinely the results of these examinations to
the NASD or NYSE. The same lack of interchange exists concerning cause
examinations and the imposition of informal disciplinary sanctions on

26/ The options exchanges represent that they forward to one another a
copy of anv letter sent to a common member firm noting deficiencies
found in routine examinations. The Options Study found, however, that
letters of comment may not reflect all of the violations found during
an examination, and, thus, to rely exclusively upon a review of
such correspondence to prepare for a routine or cause examination
may be inadecuate and misleading. See n. 19, infra.

508

member firms and information concerning Regulation T extensions. In
addition, there are no established procedures among the SRCs for the
interchange of customer complaints. These complaints may be valuable
because they can be used to detect potentially troublesome sales
oractice activities at a firm. 27/ The Options Study has found
instances in which an SRO has investigated a customer complaint against
a salesperson in ignorance that other customers had complained to other
SROs about the same salesperson. 28/ The number of complaining customers
freouentlv is an important measure of the magnitude of a suspected
or obi em.

The failure of the SROs routinely to share data is a serious short-
corn inq in their compliance programs. The consequences are illustrated
bv the following case history:

Between 1974 and 1978, a major retail firm was the subject of eight
different routine sales practice examinations by three different SROs.
Collectively, these SROs sent the firm five letters of caution and one
letter of "education." In addition, formal charges were filed against
the firm in 1976, which were settled when the firm agreed to pay a $4,000
fine. The results of these examinations and the related informal disciplinar
actions were not shared among these SROs. A summary of these examinations
and the action taken on them aDpears in the following table.

27/ See n. 24 and accompanying text, supra.

28/ A summarized history of the findings and dispositions of SROs

routine and cause examinations of one such firm appears at Appendix D.

509

tjcaiiiininy

£>KU

Date
or i^xam

Ittbfc;

y/74

UXJt,

y/74

y/75

Caut,

NYbt

Table II

Sumiary of SHU Examination and
Disciplinary Action as to Firm XYZ

Options Kelated Violations Noted

Inadequate or improper account
documentation.

Inadequate or improper account
documentation; missing or detective
discretionary trading agreements;
unsuitable recommendations; position
limit violations; lailure to file
position reports.

Inadequate or improper account docu-
mentation; failure to adhere to rules
governing opening of accounts; false
and misleading representations Dy a
salesman; inadequate or unqualified
supervisory personnel; check kiting
oy a customer.

Inadequate or improper account docu-
mentation; failure to adhere to
rules governing opening of accounts.

Inaaequate or improper account
documentation; failure to adhere
to rules governing opening of
accounts; missing or defective
discretionary trading agreements;
failure to file position limit
reports .

None

Inadequate or improper account
documentation; failure to adnere
to the rules governing opening
of accounts; improper extension
or credit; defective confirmation
notices.

y/77 Inadequate or improper account

documentation; failure to adhere
to tne rules governing opening of
accounts; improper nominee account;
failure to comply with the "know
your customer" rule.

10/75

4/ 7b

6/ 7b
b/77

Action Taken
Letter of Education
Letter of Caution

Verbal Caution

Letter of Caution

Statement of charges
filed; firm settled
proceedings by paying
$4,000 fine.

None

Letter of Caution

40-940 O - 79 - 35

510

Several observations may be made concerning this example. 29/ First,
sharing of examination data would have enabled each SRO to focus its
routine examinations so that problem areas or individuals could have
been better scrutinized. The NYSE's 1976 examination, for example,
found no options related violations, although the CBOE's examination
only four months earlier had found several potentially serious violations.
If the NYSE had been aware of the CBOE's findings, its examiners could
have conducted their review to ensure that they did not overlook similar
violations or to verify that violations cited by the CBOE had been re-
medied. 30/

Second, the sharinq of information about informal disciplinary
actions (letters of caution, etc.) would have placed each SRO on notice
that another SRO's orevious attempt to resolve a problem by an informal
sanction apparently was not effective. The failure of SRO sanctions to
correct repeated violations became apparent to the Commission's staff as
a result of a detailed examination in 1978 of certain of the firm's branch
offices which had received substantial customer complaints or which
had enqaqed in aqqressive advertising campaigns. 31/ The staff found

29/ Table II also illustrates the need for increased coordination
of routine examinations among SRCs. See pp. 30-32, infra.

30/ See also Appendix D.

31/ The Commission's staff examination included an analysis of more
than 500 customer accounts and inspections of ten branch offices.
The staff also took testimony from nine branch managers, 27 salesmen
and four managers in the firm's options department. In addition,
approximately 700 customers were questioned about their accounts
either by oersonal contact or through questionnaires. For an over-
view of SRO examination techniques, see pp. 44-63 and Appendix G.

511

indications of a aoparently serious violations of the federal secu-
rities laws, Commission rules, or SRO rules. Applicable SRO rules
qovernim the opening of accounts apparently had been violated in
aooroximatelv 65 percent of accounts reviewed for that purpose (113
of 171), and approximately 50 percent of the accounts reviewed for
nroner account documentation (62 of 123) did not appear to be properly
docur^ented . 32/ The examination also revealed that several registered
representatives and supervisors may have engaged in false and misleading
Dromotional campaigns and fraudulent trading practices in options
accounts. 33/ The Commission's staff has recommended that an administra-
tive rroceedinq be commenced naming as respondents the firm and 17
of its registered representatives and supervisors.

The Cot ions Study undertook to ascertain what compliance information
existed in the files of the SROs with respect to these 17 individuals and
recuested the NYSE, M\SD, AMEX and OBOE to furnish such information con-
cerninn them. 34/ The following table summarizes the responses received by
the Cotions Study.

32/ These accounts were selected for analysis because they were
serviced by reaistered representatives who had high options
commission income.

33/ Cne of the branch offices examined by the Commission's staff had
been examined by the NYSE in June, 1977. The NYSE had found a
hioh oercentaqe of accounts without requisite documentation and
had sent the firm a letter of caution which cited, among other
things, these deficiencies. These problems had not been remedied
by the time the Commission's staff inspected the office six months
later .

34/ The MSE and PSE were not contacted because they do not register sales-
persons for their member firms and, thus, do not have any records. The
fflLX was not contacted because the fflLX staff had previously informed
the Cotions Study that the PHLX had never received' a noticeof a ter-
mination for cause and had not conducted any options sales practice
cause examinations.

512

Summary ot SRJ Intonnation
on Selected Securities Salesmen 35/

INDIVIDUAL

NYSh

NASD

QjQE

Preliminary

Pending

No data

investigation

investiga-

into cnurning

tion arising

and misrepre-

out ot

sentation in

termination

options account.

for cause.

No data

Letter ot

No data

caution sent
oy Ainex l/7d.

Subject ot
investigation
in 1974 tor
alleged cnurn-
mg and unsuit-
aole trades in
options. Closed
witnout action.

No data

AMEX
No data

No data
No data

Letter ot
caution 1/78

Namea as
detendant in
private civil
action.

No data

No data means that tne SKG iniormed the Options Study staff that its files
dia not contain any relevant lntormation on the individual in question.

35/ Altnougn not summarized in this table, some, but not all, SROs were aware
ot tne Commission's investigation into certain of these individuals.

513

'facie III (continued)

INDIVIDUAL

nyse

NASD

CBOE

AMEX

No aata

No data

Pending
cause exami
nation arising
out ot

customer com-
plaint of un-
suitable re-
commendations .

No data

No aata

No data

Censured
1976 for
permitting
unregistered
salesman to
solicit orders.

No data

Pending cause
examination
into termina-
tion tor
cause.

No data

No data **

No data

Defendant in
private civil
action.

No data

buoject ot
investigation
in 1970 tor
alleged un-
suitable
transactions.
Ciosea with-
out action.

No data

Tne NYbE originally deterred to tne Amex on this matter, but the Amex "lost"
jurisdiction when tne salesman cnangea firms. The Amex advised the Options Study,
nowever, that it nad no information on this individual.

514

Table III illustrates how the SROs' failure to share information
nay handicap severely each SRO's compliance Drogram. In monitoring
customer complaints and employee termination notices, an SRC may be
unaware that other SROs have additional information bearing on the
same problem or individual. In addition, in planning routine ex-
aminations an SRO may be unaware of registered representatives who,
because of past Questions as to the propriety of their conduct, may
warrant close scrutiny.

Sharinq of information about a firm's credit practices would
also help the SROs to identify potential sales practice abuses.
For example, chanqes in the number or pattern of Regulation T re-
ouests made by a firm, branch office, registered representative,
or involvinq a particular security may signal potential trading
abuses or compliance problems. 36/ Such a situation occurred in 1978
when reouests for extension of credit filed with an SRO by a small
retail firm increased from an average of about 70 to 400 per month.
Because in this instance the SRO did alert another SRO, which was
responsible for examining the firm, a cause examination was made,
which revealed that the firm had serious supervisory problems.

The Ootions Study believes that a sharing of these and other
types of reaulatory information among the SROs is of critical importance
to their compliance programs. This view was brought to the attention

36/ See Chapter V.

515

of the SROs, which after evaluating the issue, have agreed, in principle,
to share certain comoliance data. Some SROs have expressed reservations,
however , about whether any such interchange should go beyond customer
comolaints and the results of routine examinations and, perhaps, cause
examinations. Although these SROs have voiced concern about releasing
to other SROs letters of caution and other informal disciDlinary actions
and information pertaining to Regulation T requests, the Options Study
believes, and the above examples demonstrate that, these are very useful
sources of information for effective enforcement of SRO rules and the
Federal securities laws.

The Options Study staff recognizes that it may be time consuming
and expensive for an SRO, in connection with an inquiry into each customer
complaint or termination for cause, or in anticipation of each routine
examination, to contact all other SROs and obtain necessary informa-
tion. 37/ Moreover, it would be costly for every SRO to maintain a
set of records on its member firms and their salesmen that would be
duplicated at other SROs of which the firm is a member. These problems
could be effectively overcome through the centralization of such infor-
mation.

The Self -Regulatory Conference recently agreed to seek to establish
programs "to promote a sharing of relevant information about broker /dealer
compliance activities and to assist in the execution of complete,

37/ See, e.g. , Table III, supra, and Appendix D.

516

comprehensive and thorough examinations of such firms." 38/ Toward
this end, the Conference has agreed "that a [central] repository
could be utilized to provide each self-regulatory organization with
more information than is presently utilized for purposes of registr-
ation of personnel, customer complaints, investigations and examin-
ations." 39/ Tne repository would include "at least all information
regarding [registered representative] registration and termination,
customer complaints, and formal actions taken by [the self -regulatory
organizations] and other regulatory bodies...." 40/ The Options Study
believes that the initiatives taken by the Conference are constructive
and that they should be implemented as expeditiously as possible.
Accordingly, to improve the sharing of relevant information
among SROs, the Options Study recommends:

SROs SHOULD CREATE A CENTRAL REPOSITORY OF
REGULATORY INFORMATION ABOUT THEIR COMMON
MEMBERS AND EMPLOYEES OF SUCH MEMBERS FOR
SHARED USE ON A DAY-TO-DAY BASIS.

2. Coordination of compliance programs; Because SROs have

not shared or interchanged information on a regular basis they have

been unable properly to coordinate member firm examinations or to

38/ Letter to Richard Teberg, Director, Special Study of the
Options Markets, from the Self -Regulatory Conference, p. 7
(Oct. 6, 1978). A copy of this letter is attached as
Appendix E.

39/ Id. at pp. 7-8.

40/ Id. at p. 8.

allocate amom themselves, in an efficient manner, the compliance
resoonsibilities they share. For example, although the options ex-
changes have allocated among themselves responsibility for doing
routine examinations of common member firms, 41/ there is little
coordination between the options exchanges and the NYSE and NASD. 42/
Since there is substantial overlap in membership among these SROs,
multiole sales practice examinations of the same firm within a short
oeriod of time are not uncommon. 43/ At one firm, for example, there
were einht SRO routine examinations in four years. (Table II, supra)
In three of these vears, there were two separate routine examinations
within a month of each other, but the SROs did not compare their findings.
Even among the options exchanges, there are overlapping cause examinations
stemminq from reviews of registered representative termination notices
and customer comDlaints.

The duplication of work which characterizes the present SRC compliance
effort not only may be unnecessarily disruptive of broker-dealer offices,
but also increases costs to the SROs.

Better coordination also would help to assure that important regulatory
responsibilities are not overlooked, as has happened when one SRO mistakenly

41/ The allocation is accomplished under a five party agreement
amonq the AMEX, CBOE, MSE, FHLX and PSE, filed with the
Commission in June 1977.

42/ The NYSE and NASD have experimented with scheduling simultaneous
sales practice examinations of the same firm. While the co-
ordinated examinations apparently have reduced the burdens which
duplicated examinations would otherwise have imposed upon the
firm, the NYSE and NASD do not allocate responsibility for
the conduct of their examinations, nor do they compare the
results of related, but nonetheless distinct, examinations.

43/ See Table II, supra, and Appendix D.

518

thinks another is pursuinq a matter. The Options Study is particularly
concerned about gaps that sometimes appear in SRO monitoring programs
designed to screen and oversee the conduct of registered representatives
As already noted, such monitoring programs suffer when firms are not
truthful about the reasons for terminating an employee. 44/ But these
proqrams also suffer if an adequate investigation of a termination- for-
cause is not undertaken by an SRO because each SRO believes another
is invest iqatinq the matter.

Tne Options Studv staff discussed with the SROs its concerns about
the need to better coordinate compliance proqrams. The Conference has
stated that "measures should be taken ... to decrease or eliminate
duplication of efforts amonq self-regulatory organizations and increase
overall efficiency . . . within the industry." The Options Study
believes that the SRO resources saved by any decrease or through
the elimination of duplicative efforts should be devoted to increasing
the scope and effectiveness of SRO compliance problems.

C. Government agencies

Government agencies, particularly the Commission and the state
securities regulatory agencies, in many instances have information
that parallels the types of information retained by the SROs.

44/ See Chapter V.

519

The Commission, for example, has extensive information on file
about retail firms and their registered representatives. Some of
this information is Dublicly available, including records pertaining
to pendinq and closed administrative proceedings and civil actions,
broker dealer registration files, and certain periodic filings required
to be made bv retail firms. In addition, the Commission receives
annually more than 5,000 customer complaints against broker -dealers
and their registered representatives - more than all the SROs combined.
These complaints usually are available to SROs upon request. E'inally,
there are certain categories of documents which may not be released
to the public or SROs without formal Commission authorization. In
neneral, these are subpoenaed documents, transcripts and other records
which are oart of investigative files.

The Ootions Study believes that information in the Commission's
files relatinq to SRO member firms and their salesmen would be useful
to the SROs in the conduct of their compliance programs. The
SROs have expressed an interest in receiving such information, if the
materials can be provided on a timely basis. But, perhaps because of
the formalities involved in getting information from the Commission,
most SROs have not souqht such information on a routine basis. 45/

Accordingly, the Options Study recommends:

SROs SHOULD ROUTINELY SEEK ACCESS TO RELEVANT
COMPLIANCE INFORMATION RETAINED BY GOVERNMENT
AGENCIES, INCLUDING THE COMMISSION.

45/ The Commission's Office of Consumer Affairs, which is responsible
for the receipt and disposition of customer complaints, has informed
the Ootions Study that the Office receives more requests for customer
comnlaint information from compliance officers of retail firms than
from SROs.

520

D. Retail firms

Retail firms are required to maintain books and records which
are the primary source of information regarding their current financial
condition and recent operational developments, and also the manner in
which they and their registered representatives service public customer
accounts. 46/ Some of this information is required to be reported to
the SROs, the Commission, or both, and some information is typically
reviewed by SROs only during routine examinations.

The Options Study found two problems concerning the utilization of
member firm data by SROs. First, while most information kept by member
firms is readily available to SROs, there are two important types of
data which are not always easily accessible — customer account in-
formation and customer complaints. Second, since customer complaints
and member firm internal disciplinary proceedings are not routinely
filed with the SROs, the SROs cannot make effective use of this
information.

1. Accessibility of customer complaints and account information;
The problem of locating documents is twofold: first, firms frequently
keep customer complaints only in the branch office which received them
- instead of keeping them there and also centralizing tham in the firm's
headouarters office. Second, there is no requirement or general practice
that retail firms maintain in their branch offices full information

46/ See 17 CFR 240.17a.

521

respectinq customers who have accounts at those offices, although some

firms do so.

The Ctotions Study's own ability to find customer -related information

was hampered by firms which either could not find, or could not

assemble, complaints or customer account records. In February 1978,

as part of its information gathering phase, the Options Study requested

more than 50 maior reqistered brokerage firms to submit copies of all

ootions related customer complaints received by those firms since the

commencement of listed options trading. Che national firm responded

nearlv two months later :

"At the time of our recent merger [with another
national firm], almost all of [the other firm's]
documents were sent to a warehouse. It would
impose a great hardship upon [this] firm to
retrieve this information. The records that
were sent to the warehouse were filed in a man-
ner that would make it very difficult for us to
retrieve them at this time."

In addition, several other major wirehouses took months to comb
their branch offices for options related customer complaints and even
then failed to Droduce the large numbers of letters which the Commission's
own files indicated the firms had received.

The Ctotions Study's letter also included a request for the account
statements, new options customer account cards, and options agreements
for all complaining customers. Some firms had great difficulty locating
these materials, although the firms are required to keep such documents

522

in an accessible place. 47/ Some firms never did locate or produce all
such records.

The Options Study's experience is similar to that of the staff of
the Commission's regional offices who have provided the Options Study
with copies of reports of their inspections of broker-dealer firms. Those
reports describe reoeated difficulties in locating documents. In many
instances the firm's documents, when ultimately Drovided, were illegible.

The SROs have encountered similar difficulties in obtaining

relevant retail firm records. The CBOE, for example, recently

spent over 1,000 man-hours conducting an examination of a nationwide

retail firm which maintained customer records at 140 branch offices.

The examiner concluded in his report that it was "virtually impossible

to conduct an adeauate examination" of the firm and noted:

"The time soent was not caused by the com-
plex itv of what proved to be the final
requlatory problems at issue in the Report
which follows, but rather the difficulty in
getting to the point of being able to gather
information so as to objectively measure the
degree to which a problem existed."

Customer complaints about a brokerage firm or its registered representa-
tives are a significant information source about the firm's sales practices.
Recoanizing the importance of complaint information, the NASD adopted
a rule in 1965 reouiring that member firms establish either a complaint

47/ See 17 CFR 240.17a-4.

523

file or an index of complaints in each branch office where a person
havinq supervisory responsibility is assigned. The NYSE, NASD and
the ODtions exchanqes review available complaint files during examina-
tions of a firm's headouarters office, but the NYSE is the only SRO
which has represented that it examines branch offices routinely. Thus,
examiners from SROs frequently are not aware of customer complaints
that are not on file at the firm's home office.

Conversely, absence of relevant customer account records in many
branch offices has been found by the Commission's staff to be a sub-
stantial impediment to meaninqful branch office examinations. In
fact, the absence of these records has been cited by the options
exchanqes as one rationale for not conducting branch office examinations,
It is not surorisinq that the Options Study has found in branch offices
a hiqh incidence of sellinq practice abuses that have gone undetected
by the SRO compliance programs. 48/

The CBOE has recently interpreted its general recordkeeping rule
to reouire that a "separate, central file for all options-related com-
plaints" be maintained by every member firm. The file may consist
of a "log, index or other listing" which would allow complaints
to be "easily identified and retrieved." 49/ The CBOE interpretation

48/ See Chapter V.

49/ CBOE Rule 15.1, Interpretation .01.

524

represents a forward step, but, of course, is limited in scope since

it applies only to CBOE members and only to options-related complaints.

The Options Studv believes that all firms should keep copies of all

customer complaints and customer account and suitability information

in their home offices as well as the branch office where the customer

account in issue is serviced.

Accordinqly, the Options Study recommends: 50/

THE SELF-REGULATORY ORGANIZATIONS SHOULD ADOPT
RECORDKEEPING RULES WHICH REQUIRE THAT MEMBER
FIRMS KEEP COPIES OF CUSTOMER COMPLAINTS, CUS-
TOMER SUITABILITY INFORMATION AND CUSTOMER
ACCOUNT STATEMENTS AT BOTH THE BRANCH OFFFICE
WHERE THE ACCOUNT IN ISSUE IS SERVICED AND
THE HEADQUARTERS OFFICE.

2. Reporting requirements: Customer complaints often come to an SRC
attention only when the SRO does a routine inspection of a broker-dealer
firm, and bv that time it may be too late for the SRO to protect the
ccmolainant or other customers from injury. Recognizing this fact,
the NYSE in 1971 adopted a rule which requires that member firms notify
the exchange of "major complaints." 51/ The NYSE staff has interpreted
this rule to reouire that member firms report "any written complaint"
that involves a "claim of actual damaqes in excess of $10,000Y . . .
[a] claim for damaqes which is settled for an amount exceedinq $2,500,
or . . . alleqations of theft . . . forqery ... or similar dishonesty."

50/ See also Chapter V.
51/ NYSE Rule 351(c).

->J,)

The NYSE is the only SRC that requires its members to report customer
complaints.

Under the current NYSE rules, the complaints required to be reported
to the NYSE constitute only a small percentage of the total number of
complaints received directly by member firms. The following Table
compares the estimated number of customer complaints received by two
maior NYSE member firms with the number of customer complaints regarding
those two firms reported to the NYSE.

Table IV
Selected Comparison of Complaints

Reported to NYSE and Complaints

Received by Two NYSE Member Firms

in 1977

Estimated

No. Complaints

Firm

Reported to NYSE *

Received by the Firm

540

1140

Statistics as to the number of complaints reported to the NYSE were
furnished by the NYSE. Statistics as to the number of complaints
received by these firms were furnished to the Options Study by
the Commission's Office of Consumer Affairs based upon submissions
to that Office by these firms.

Most of the comparatively large number of complaints which are not
reported to the NYSE involve the administrative operations of the firm,
such as the alleged failure to deliver securities or funds to a customer,
and are not direct allegations of selling practice abuses. Nonetheless , as

40-940 O - 79 - 36

526

the Soecial Study of the Securities Markets noted in 1963 and, as the
Commission's staff has experienced on several occasions, operational
complaints can be important enforcement leads and can aid in evaluating
other indications of possible violations. 52/

The Options Study believes that customer complaints are such an
important source of information that all complaints should be filed
by member firms with the SROs of which they are members and included
in a central repository of compliance information accessible to all
SROs.

In addition to providing expeditious, economical access to such
data, the centralized file could enhance significantly the ability
of SROs to detect potential selling practice abuses. 53/ The file
could be programmed to automatically identify individuals, firms
and branch offices which have been the subject of a large number
of customer complaints or certain types of complaints. Periodic
analyses of complaint data could be provided to SROs to enable them
to identifv trends and subjects which appear to warrant close attention

The centralized file could also assist SROs when evaluating
new complaints and termination notices to decide whether the situation
reouires immediate attention or may be deferred to the next routine
examination. Moreover, in anticipation of a routine examination, the

52/ See Special Study Report, Part IV, p. 522.
53/ See pp. 28-30, infra.

527

file could provide the examinim SRO with data that may help identify
matters that deserve special review, such as

— reqistered reoresentatives with multiple complaints of
alleged sellinq practice abuses,

— branch offices with concentrations of complaints, and

— reqistered representatives with particular types of complaints,
such as unsuitable recommendations or excessive trading. 54/

As previously noted, the Self-Requlatory Conference tentatively has
aqreed that a centralized repository could enhance the efficiency and
effectiveness of their compliance proqrams. 55/ The Conference also
aqreed that such a repository would assist in overseeing the conduct
of a reqistered representative and "provide SRO's with more comprehensive
data bv which to judge his actions."

.Accordingly, the Options Study recommends:

THE SROs SHOULD AMEND THEIR RULES TO REQUIRE THEIR
MEMBER FIRMS TO SUBMIT ALL COMFLAINTS RECEIVED FROM
CUSTOMERS TO A CENTRAL DATA FILE, WHICH SHOULD ALSO
CONTAIN COMFLAINTS RECEIVED DIRECTLY BY THE SROs
AND THE DISPOSITION OF SUCH COMPLAINTS.

In order to ensure that this centralized file is complete, the

Ootions Study believes that complaints received by the Commission

should be included in it. Accordingly, the Options Study recommends:

54/ For a more detailed discussion of the possible uses of the file
see letter from Van P. Carter to Gerald Foley (NASD), Oct. 11,
1978 (Acoendix F) .

55/ See po. 28-30, infra.

528

THE COMMISSION SHOULD TRANSMIT FOR INCLUSION
IN THE CENTRAL FILE A RECORD OF RELEVANT
INFORMATION ABOUT ALL BROKER-DEALER COMPLAINTS
IT RECEIVES UNLESS RELEASE OF SUCH INFORMA-
TION WOULD BE CONTRARY TO LAW OR WOULD HAVE
AN ADVERSE AFFECT UPON A PENDING OR PROPOSED
INVESTIGATION, OR OTHERWISE WOULD BE INAPPROPRIATE.

The Options Study has been advised that the NASD, with the concurrence
of the other SROs, has established a pilot program for the centralization
of sales practice related complaints. This program, which is scheduled
to commence in late January, 1979, envisions the inclusion in a central
data file of all sales practice related complaints received by the SROs,
to be filed under the name of the firm or the registered representative
aqainst whom a complaint has been filed, if furnished.

The SROs are evaluating how they may interchange other categories
of compliance information, including customer complaints that are not
directly sales practice related.

Information about a firm's discipline of its employees and related
compliance matters also can be an important source of regulatory information
As previously noted, a retail firm is required to advise the SROs about
one form of employee discipline — i.e., the firing of an employee
for cause. 56/ In addition, when an employee is terminated from employment,

56/ The staff of the PHLX informed the Options Study that the PHLX has
never received a notice of a termination for cause, although the
Options Study has verified that certain PHLX members have filed
such notices with other SROs.

529

the firm is required to state whether the registered representative had
been the subject of any customer complaints. 57/

Fir inn an emoloyee for misconduct is a rather drastic action, how-
ever, and retail firms freouently sanction their salespersons in other,
less severe wavs, includinq levying fines and withholding commissions.
Nevertheless, the NYSE is the only SRO that requires that its members
file recorts of such actions against employees.

The Options Study has found, moreover, that, on occasion, firms
have failed to report the termination of a registered representative so
that such information cannot be known by the SROs until the next routine
sales oractice examination, which may not occur for a year or more due
to the SROs' inspection cycles. By that time, the examining SRO may
have lost jurisdiction over the registered representative because he is
no longer in the securities industry or is affiliated with a firm that
is not a member of the examining SRO. The examining SRO, therefore,
may be unable to investigate thoroughly apparent violations of SRO rules
or Federal law, or to seek effective remedial action.

57/ As noted in the Selling Practices Chapter, the Options Study has
found instances in which termination notices did not describe
accurately the circumstances surrounding the termination of employ-
ment of some salesmen. At least one SRO compliance official has
acknowledged to the Options Study that most firms "say as little
as they possibly can" on termination notices and that in many
cases the reasons for the discharge are "oblique," apparently because
firms are concerned about possible civil liability for defamation
in the event that statements made on the termination notice cannot
be verified. See Chapter V.

530

Accord inalv, the Options Study recommends:

SROs SHOULD AMEND THEIR RULES: (1) TO RECUIRE
MEMBER FIRMS TO NOTIFY SROs PROMPTLY CF ALL INTERNAL
DISCIPLINARY ACTIONS AGAINST EMPLOYEES, AND (2) TO
PROVIDE THAT WHEN A REGISTERED INDIVIDUAL'S EMPLOYMENT
IS TERMINATED OR HE RESIGNS FROM A MEMBER FIRM, THE SRC
SHALL RETAIN JURISDICTION OVER THE INDIVIDUAL FOR A
REASONABLE TIME. THE SROs SHOULD ALSO VIGOROUSLY
ENFORCE MEMBER FIEM COMPLIANCE WITH NOTIFICATION
REQUIREMENTS.

IV. DEFICIENCIES IN SRO EXAMINATIONS

Seles Dractice comoliance programs of SROs not only often fail to
make use of all available information; they also frequently fail to
detect violations because of ineffective examination and investigative
procedures, and because of inadequate allocation of SRO resources in
their examination programs.

A. Limited scope of examinations.

The most common procedural failure noted by the Options Study was
that SRO examinations, both routine and for cause, were so limited
in scope that clear patterns of abuse were overlooked. For example,
cause examinations conducted by SROs usually focus on only the trans-
action or narrow Problem reported to the SRO staff and are seldom
broadened to determine whether there are additional, unreported
problems. The Options Study reviewed numerous SRO cause examinations
which were closed without remedial action or with inadequate sanctions
because the limited analysis did not disclose serious selling practice
violations which an inquiry of broader scope should have detected.

A recent example of the unnecessarily narrow scope of SRO investi-
qations is a cause examination of a member's branch office initiated

531

bv an SRO in 1977. The SRO's market surveillance system detected
aooarentlv imoroper transactions in restricted options. 58/ A cause
examination was commenced which established that the registered
representative, Mr . X, had effected discretionary opening sales in
a restricted ootions series for the accounts of 24 customers. The
examination also found certain violations of the SRO account opening
rules and rules relatinq to discretionary accounts.

Therefore, the SRO, in January, 1978, sent Mr. X a letter of
caution notina the followinq aDoarent violations: (1) opening sales
in restricted options, (2) effecting trades in three accounts prior
to the receipt of options trading authorizations and approval of those
accounts for oDtions tradinq bv the firm's Registered Options Prin-
cipal, and (3) discretionarv trades in two accounts without written
authorization from customers.

Shortlv thereafter, the Commission's staff reviewed the activities
of Mr. X and found evidence suqqesting serious additional selling
practice problems. In sunmary, the staff has alleged that: Mr. X
developed and promoted an ootions writing program and represented
to customers that this program was designed to give his clients a
20 Dercent to 30 percent "consistent annual return;" and Mr. X handled
aporoximatelv 40 discretionarv options accounts, some of which were
for members of his family.

58/ For a discussion of restricted options, see Chapter III.

532

Althouqh the accounts managed by Mr . X for his family realized
net qains during the period January - October, 1977, a preliminary
analysis of 23 other discretionary accounts managed by Mr . X showed
that all 23 accounts had sustained a net loss during this period.
Tbtal losses to these customers appear to exceed $197,700, with the
average customer loss being about 16.4 percent of the original invest-
ment. Commissions appear to have accounted for about $129,900 of
this loss, or about 10.8 percent of the funds invested. Firm records
disclosed that in 1977 Mr. X generated gross commissions of about
$400,000, of which $320,000 arose through options transactions, making
Mr. X the branch's largest producer and accounting for about 58 percent
of the branch's total options business. The Commission has approved
a recommendation from its staff that Mr . X be named as a respondent
in an administrative proceeding, but the guilt or innocence of this
individual has yet to be adjudicated. 59/

The SRO which conducted the cause examination reviewed six of
the 23 accounts analyzed by the Commission's staff, but the SRO only
souqht to determine whether trades had been effected in restricted
options and whether the firm had complied with the appropriate account
opening and approval reauirements. Other firm records which would
have suqqested the additional problems were not reviewed. The senior SRO
staff official who supervised the inquiry stated that further inquiry

59/ The staff also recommended, and the Commission concurred, that
the firm be named as a respondent for its alleged failure to
supervise Mr . X. adequately.

533

was unnecessary once the cause examination established purchases of
restricted options and the absence of account approval to trade options.

Another example concerns a 1974 episode in which a customer com-
plained to a larqe retail firm that he had been induced to open an
oDtions account based on misrepresentations by one of the firm's regis-
tered reoresentatives, Mr. P, who allegedly had told the customer
that he should expect to receive a 12 to 20 percent return on his
investment with a maximum loss potential of only 1 percent of the
capital invested. The customer also complained that unauthorized
trades had been effected in this options account. When the firm confronted
Mr. P with these charges, he admitted, in the presence of the customer,
that the complaint was "basically true." Mr. P. was therefore permitted
to resian from the firm and his personal account was charged about
$9,000 to reflect adjustments by the firm in the customer's account.

The same customer thereafter complained to one SRO which referred
the ccmolaint to another SRO. The second SRO conducted an investigation
durinq which Mr. P again admitted executing unauthorized trades in the
customer's account. A statement of charges was thereafter filed
aqainst Mr . P. In his response, Mr. P again admitted that he had
effected unauthorized trades in the account and that the customer
"just did not understand the risks involved."

In early 1976, the SRO's disciplinary panel found that Mr. P had
violated SRO rules by effecting trades without written authorization

534

from the customer. The panel, however, also found, as mitigating cir-
cumstances, "that there [was] no evidence of a profit motive" on the
part of Mr. P - and suspended Mr. P. from association with any member
firm for only 30 days.

The SRO's investigation consisted only of asking the firm for cer-
tain documents relevant to the precise allegation of the complaining
customer . Tne SRO did not inouire whether the firm was aware of any
other problems involving Mr. P. None of Mr. P's other options accounts
was examined; none of his supervisors were interviewed; none of Mr.
P's other customers were spoken to; no investigative testimony was
ta ken .

Had a broader inquiry been made, the SRG would have found that
during the pendency of the investigation Mr. P and the firm were sued by
another of Mr. P's customers in the same office. This second customer's
conolaint aqainst Mr. P included all the allegations made by the first
customer and several additional more serious charges. An SRO invest i-
qator probably would also have uncovered apparently misleading advertising
materials used by Mr. P without the required SRO clearance. Tne SRO disci-
Dlinary panel did not have any of this additional information before
it when it reached its mitigating conclusion that Mr. P. did not have
any "profit motive" in violating SRO rules.

Tne sales practice examination checklist designed by each SRO
to "guide" its staff in their examinations also reflects the limited
orientation of SRO routine examinations. Tne examination normally

535

focuses onlv on those rules concerning (1) reporting and filing require-
ments, for example, verification of registration and qualification of
salesmen; (2) oDening new accounts; (3) supervision of accounts;
(4) suitabilitv; (5) options position and exercise limits; (6) margin
reouirements; (7) exercise allocation procedures; (8) sales literature
and advertising; and (9) books and records. A review is also usually
made of the firm's records of customer complaints. The NYSE is the
onlv SRO that represents that it routinely evaluates the firm's
internal compliance system for overseeing the conduct of registered
representatives. SRO officials contend that these checklists are
only "quides" to be used by examiners, but the examination files
reviewed and interviews conducted by the Options Study indicated
that, in general, most examiners appear to limit their examination
to the items and Drocedures covered by the checklists.

The limited scope of routine examinations by SROs seems to result
from deliberate SRO policy. In interviews with the Options Study,
SRO staff members have consistently maintained that an SRO should
not examine an area of firm activity not covered by their checklist
unless there is independent evidence of abuse in that area. Therefore,
examiners do not routinely review those additional aspects of a firm's
ooerations which may Drovide material leads to possible selling practice
abuses. 60/ Such areas include a firm's programs for acquiring new customers,

60/ The Options Study also found that some SRO examiners fail to respond
to items on the checklist or respond in an incomplete or cryptic
fashion, which adversely affects the likelihood of adequate super-
vision of examiners.

536

and the use of worksheets and other selling tools used by sales-
persons. 61/ Moreover, as previously noted, the NYSE is the only
SRO which reoresents that it routinely examines branch offices.

A further indication of the limited scope of options sales prac-
tice examinations is that options exchange examiners are often unaware
of the firm's non-options activities. Most retail firms offer a range
of securities products, and information about other areas of firm
activity may be relevant to the examination. If, for example, a
registered representative has been the subject of several customer
complaints for his alleged abuse of discretionary trading authority
in connection with transactions in stocks, an options sales practice
examination should include a review of the discretionary options accounts
serviced by this individual. Likewise, if a firm has been censured
for inadeouate supervision standards with respect to trading in listed
or over-the-counter stock or municipal securities, the examiner should
take that fact into consideration during an options sales practice
examination.

Accordinqly, the Options Study recommends:

SROs SHOULD REVISE AND BROADEN THEIR SALES PRACTICE
EXAMINATIONS, INCLUDING THEIR CHECKLISTS AND GUIDE-
LINES, TO (1) ASSURE THAT EXAMINERS WILL REVIEW ALL
ASPECTS OF A FIRM'S PROCEDURES AND DEALINGS WITH
THE PUBLIC, INCLUDING THE SOLICITATION OF CUSTOMERS
AND MARKETING OF SECURITIES, (2) PROVIDE THAT EACH
SALES PRACTICE EXAMINATION WILL INCLUDE A THOROUGH
EVALUATION OF THE FIRM'S INTERNAL COMPLIANCE SYSTEM
AND (3) PROVIDE FOR ON-SITE INSPECTIONS OF BRANCH
OFFICES AS APPROPRIATE.

61/ For a discussion of the uses of worksheets, see Chapter V.

537

B. Poor selection of accounts for review

There appears to be no uniform practice among the SROs concerning
the type of accounts selected for review during a routine examination,
although most SROs include a review of some discretionary trading accounts
and examiners are starting to focus more frequently on accounts serviced
by registered representatives with high options commission income. The
options exchanges allow their examiners to select the accounts to be
reviewed, and, in most cases, the examiners make their selections on a
"randon" basis, but no SRO has evaluated its account selection procedures
to determine whether the "random" selection made by its examiners is, in
fact, random and whether the number of accounts reviewed is a statistically
valid sample given the number of accounts at the firm.

In any event, random selection of accounts alone has not proven to

be an effective way to identify sales practices problems, such as unsuitable

recommendations or excessive trading. A process which includes a statistically

random selection together with more structured account selection procedures

would be more likely to detect accounts which may disclose sales practice

violations. 62/ Tb supplement a statistically valid random selection of

accounts, an examiner could select the accounts of:

(1) salespersons who have been the subject of SRO or
firm disciplinary action for excessive trading,
executing unauthorized trades or similar activity;

62/ Accountants and statisticians refer to this process as "stratifica-
tion" and recognize that judgment is an important element of this
process in order for the selection to be effective.

538

(2) salespersons who are the subject of multiple or serious
customer complaints;

(3) branch offices which have a high ratio of options
commissions to total commissions, which employ high
volume salesmen, or which have been the subject of
multiple customer complaints; and

(4) accounts which have extensive or irregular trading
activity, which repeated Regulation T extensions
have been requested, or which are managed by an
investment advisor.

The NYSE is the only SRO which utilizes account selection techniques
of this nature. 63/ When the NYSE examination team enters a firm, the
examiners review monthly account statements, commission runs, credit
records and internal audit reports to identify those accounts, including
those maintained by certain salespersons and branch offices, which should
be examined more closely. Perhaps because of its account selection
techniques, the NYSE identifies more potential violations of rules relating
to suoervision, suitability and handling of discretionary options accounts
than do the options exchanges, as reflected in Table V on the next page.

Tb improve the ability of the SROs to detect selling practice abuses,

the Options Study recommends:

SROs SHOULD REVISE THEIR ACCOUNT SELECTION PROCEDURES
WHEN CONDUCTING ROUTINE EXAMINATIONS TO USE A STATISTI-
CALLY VALID RANDOM SELECTION OF ACCOUNTS TOGETHER WITH AN
ACCOUNT SELECTION PROCESS WHICH WOULD BE DESIGNED TO
IDENTIFY THOSE ACCOUNTS WHICH HAVE A HIGHER PROBABILITY
OF BEING THE SUBJECTS OF PARTICULAR SALES PRACTICE ABUSES.

63/ Other SROs have begun to emphasize to their examiners the need for
better account selection. As one SRO official put it: "We've been
trying to beat it into their heads. Use some thought in their
[account] selection procedures."

539

Table V

Summary of Types of Options Related Violations Detected
by SROs in their 1977 Sales Practices and Capital/Sales
Practice Examinations of Firms with Options
Commission Income in Excess of $1,000,000

SRO

PSE

PHLX

mtx

CBCE

"NYSE

Examinations Analyzed
by the Ootions Study

No. of ^ooarent
Pule Violations

4':

Percentaae of Violations
bv Tvoe of Rule 1/

Ooeninq of Account 2/ 40%

Registration of Salesmen

and ROPs 0

31%

78%

41%

35%

Supervision, Suitability
of Recommendations, and
Discretionary Accounts

Exercise Assiqnment
Procedures

Recorts Required to be
Filed with SROs

Financial Resoonsibil:

ity

and Credit

Fraud or Churn inq

Other _3/

Total

100%

1 / The submission bv the NYSE did not cite specific rules; percentages are

comouted on the basis of the categories provided by the NYSE.

2 / Includes obtaining option aq.eement and statement of customer's financial

condition, investment objectives and needs; branch office manager approval
ROP aooroval .

3 / For examole, defective confirmation notices; OCC rules; sharing of offices
without SRO authorization; defects in brokers' blanket bond; delivery of the
OCC nrospectus; markinq of order tickets.

540

C. Inadequate depth of account examinations
The Ootions Study asked the SROs to submit certain information
Dertaininq to their routine sales practice examinations, including,
the number of: hours spent conducting examinations; interviews con-
ducted; accounts reviewed; and days required to prepare the examina-
tion reoort. 64/ These statistics indicate that the scope of sales
practice examinations varies markedly among the options exchanges
and the NYSE. The Options Study has also documented variations in
the scope of examinations conducted by the same SRO. In one instance, .
an octions exchange examined a firm in 1976 and reviewed 600 of the firm's
2,200 options accounts. The following year the sales practice examination
bv the same options exchange included a review of only 47 of the firm's
2,900 accounts. The examining exchange could not account for the reduction
in the number of accounts reviewed .

The Options Study has also reviewed several examinations in which the
account review may not have been as thorough as the SRO's representa-
tions sugqest. In one instance, an SRO represented that it spent 95
hours at a large retail firm conducting an options sales practice exami-
nation, and that 6,000 of the firm's 7,000 options accounts, were "reviewed,
Assuming that the entire 95 hours were devoted to such "reviews," the
examiner spent an average of 57 seconds per account.

64/ For a summary of this data, see Appendix G.

541

With reqard to the depth of routine examinations, none of the SROs
routinely review accounts for possible excessive trading. As for general
"suitability" reviews, the CBOE and NYSE contend that as a part of every
sales practice examination their examiners review customer accounts for
compliance with applicable suitability standards. The AMEX, PHLX and
PSE represent that a suitability review is made "when necessary." The
nature of suitability reviews varies significantly among SROs, but, in
oeneral, the examiner compares information on the customer's account
card to the latest monthly statement to determine whether the trading
is consistent with the customer's objectives and financial situation.

CBOE examiners aopear to conduct the most thorough options re-
lated suitability reviews amonq the SROs whose procedures were examined
by the Options Study. In addition to reviewing the new account card,
the CBOE examiner prepares a written evaluation of every account re-
viewed, which includes an assessment of the trading strategies utilized
by the customer and the salesman and, frequently, the relative risks
of selected transactions. At the other SROs, the examiners usually
limit their suitability review to a check of the account documentation
to verify that the customer is properly approved to trade options and
a review of the latest monthly statement to determine whether the cus-
tomer's trading is consistent with such approval. If deficiencies are
encountered, additional inouiries may be made, including an assessment

40-940 O - 79 - 37

542

of trading strategies. None of the SROs routinely conduct a profit and
loss analysis of customer accounts. 65/

There is evidence, however, that even the suitability reviews
conducted by the CBOE are not sufficiently thorough. In most instances,
the CBOE review does not include a computation of actual gains and
losses, and, when such an analysis is made, the examiner frequently
does not take into consideration open options positions which, due to
their contingent or actual liabilities, may affect the profitiabilty
of the account. 66/ Moreover, in virtually every routine examination,
reviewed bv the Ootions Study, when potential suitability violations
were detected by the CBOE examiner , the problem was resolved in favor
of the brokerage firm, not the customer. In most instances, this
resolution was based primarily upon information obtained from the
firm, which was not supported by other written documentation, such
as a statement from the customer to the firm stating his financial
obiectives or the source of his income. Despite the seriousness of
some potential suitability violations noted in the examination reports,

65/ The Ootions Study believes that the profitability of an account should
be readily ascertainable by the customer and the firm. Accordingly, in
Chapter V the Options Study recommended that customer account statements
reflect the status of the account marked to the market and commissions
charged against the account. Tne Options Study believes that SROs
should routinely evaluate the profitability of accounts reviewed during
routine examinations.

66/ For a discussion of the need for a profit/loss analysis, see Chapter V.

543

the examiner did not contact the customer to obtain additional information,
or otherwise attemot to verify representations made by the firm.

One reason for the lack of thoroughness exhibited by SROs in their
account reviews is the time consuming nature of such reviews. In fact,
supervisory personnel at each SRO have explained that the two most time
consuming tasks in an examination are (1) to review customer account do-
cumentation to assure that the relevant documents are present and complete,
and (2) to analvze trading in a customer account for suitability, excessive
trading and abusive selling tactics.

The NYSE has begun to explore whether these and similar tasks could
be oer formed more efficiently through the use of computers. With the
cooperation of certain of its members which utilize a particular service
bureau, the NYSE has developed a computer program that analyzes customer
accounts using information from the firms' own computerized account
records. The pronram became operative for capital examinations in 1977.

For those firms vhich utilize the particular service bureau, the
NYSE computer program can (a) select customer accounts for review based on
securities held, (b) select margin accounts for review, (c) prepare
a list of Partner, office and employee accounts, (d) analyze security
positions for concentration, (e) prepare summary reports on customer
eouity and the distribution of customer debit and credit balances. Within
the next few months, this program will be further enhanced to permit
the identification of those customer accounts that (1) are missing relevant
account documentation, (2) have incurred large commissions, and (3)
have extensive options positions.

544

Chanter V includes a recommendation that brokerage firms selling

ootions be able to review customer accounts to determine commissions as

a percentage of eouity, realized and unrealized losses as a percentage

of eouity, and unusual credit extensions or trading patterns. Adoption

by the SROs of a similar capability would provide additional information

to examiners and significantly assist in identifying accounts that require

detailed analysis.

Tb help ensure that SRO examiners detect potential sales

practice violations, the Options Study recommends:

SROs SHOULD CONDUCT MORE COMPREHENSIVE ANALYSES
OF CUSTOMER ACCOUNTS, INCLUDING AN EVALUATION OF
THE NUMBER AND TYPE OF TRANSACTIONS IN THE ACCOUNT,
RELATIVE RISKS, ACTUAL AND UNREALIZED PROFITS AND
LOSSES, COMMISSIONS, AND SUITABILITY OF TRADING
STRATEGIES FOR INDIVIDUAL CUSTOMERS. SROs SHOULD
ALSO DEVELOP AND USE COMPUTERIZED SYSTEMS TO AID
IN THE ANALYSIS OF CUSTOMER ACCOUNTS.

D. Reliance on firm for assistance

In addition to their often limited analysis of firm records during
on-site examinations, SROs tend to rely heavily upon the member firm
to qather and furnish much of the information required in a cause exami-
nation or other follow-up inquiry, such as documents pertaining to
a customer's account. The reliance by SROs on member firms to get
and analvze compliance information, if reasonably applied, might
result in more efficient use of the SRO's resources. The existing promi-
nent role given member firms to provide assistance in developing inves-
tiqative information, however, raises obvious questions about the
accuracy of the result.

545

The SROs' reliance on member firms for information is particularly
susDect when Questions arise concerning the activity in the account of a
customer dealing with a branch office, since most SROs do not ordinarily
inspect branches, either routinely or in connection with a cause exami-
nation.

SROs not only rely on member firms to gather information, but also
Generally accent the firm's explanation of disputed issues of fact which
have developed during an investigation. In one case, a widowed judge
complained that her equities account had been converted to an options
account without her permission and then had been mishandled. The firm
told the investigating SRO that the customer had been fully advised by
the firm concerning the xhandling of her account and in response to a
specific SRO Question, represented that the customer had signed an op-
tions aqreement which was on file at the firm. The firm promised that
a cony of the agreement would be sent to the SRO. Based upon these
reDresentations, which were made in Auqust 1977, the SRO informed the
customer that, due to conflicting statements, the SRO could not resolve
the dispute and the matter would be closed.

Two months later , despite repeated requests by the SRO - and an
assurance from the firm that the agreement had been located - the SRO
still had not received a cooy of the agreement. Finally, on October 27,
the firm informed the SRO that an agreement could not be found, but
that one had been signed when the account was with another firm. No
further inouiry was made at that time into the circumstances sur-
round ina the handling of this or other accounts of the firm.

546

In 1976, an SRO's routine examination of one of its members identi-
fied a reqistered representative who had discretion over seventeen
customer accounts, including the account of a parochial school teacher
with an annual income of $10,000. Trading analysis of the teacher's
account showed that it had generated more than $10,000 in commissions
in five months and losses in excess of $6,000. The SRO's examiner
Questioned the suitability of the options transactions in this account,
and reauested an explanation from the brokerage firm.

Ten months later the SRO investigator's memorandum to his super-
visor recommending closing the inquiry paraphrased the brokerage firm's
earlier explanation concerning the customer's recorded net worth and
trading losses. 67/ Ch the basis of the firm's response and conversa-
tions with firm employees but without talking to the customer, the in-
vestiqator recommended that the case be closed. The closing memorandum
also reported:

...While the trading in [the school teacher's]
account over the five month period did result in
$10,000 of commissions generated, the above acti-
vity does not aopear to warrant any action with
resoect to violation of "churning" activity (sic)
especially in view of the fact that there is
no evidence to indicate that [the school teacher]
did not affirm all of the transactions effected
by [the registered representative]... (Emphasis
added . )

67/ During the investigation, however, the SRO staff did learn that

this registered representative had been sued several years earlier

by a customer for excessive trading, settling the dispute out of court

547

Had the invest iqator talked to the customer he might have obtained
"evidence" that she did not approve the transactions. In fact, several
months after the closing memorandum was written the teacher sued the
firm and the registered representative for fraud.

IP remedy the deficiences noted above the Options Study recommends:

IN INVESTIGATING COMPLAINTS, INQUIRIES OR QUESTIONABLE
ACTIVITIES, SROs SHOULD DEVELOP PROCEDURES WHICH
ASSURE TIMELY INDEPENDENT VERIFICATION OF EVIDENCE,
WHENEVER POSSIBLE.

E. Failure to resolve disputed issues of fact

SROs freouently terminate a cause examination when a factual

disDute develops between the firm and one of its customers without

dec id inn whether or not an SRO rule may have been violated. SROs

are aooarentlv concerned that a determination of wrongdoing by them

mav prejudice the firm in subsequent litigation between the firm

and the customer. Accordingly, SROs sometimes inform customers that

thev do not have "the authority to attempt to resolve" disputed issues

of fact or that, due to such a dispute, the matter will be closed

without action. Conseouently, potentially serious violations are not

investiqated .

SRO resolution of disouted issues of fact is further hampered

because SROs rarely take testimony during cause examinations. During

the period 1973-1978, it appears that the options exchanges, in the

aggreqate, have taken testimony in less than 15 cause examinations into

possible improper sellinq practices or procedures. Relying almost

548

exclusively upon lirm records anu written suomissions, the options
excnanges nave attempted to evaluate a wide range of potentially serious
iiiatters, some ol whicn involve issues as to the credibility of the
investor on the one hand and tne registered representative (or firm
orricials) on tne other.

The Options btudy believes that SROs have a statutory duty to
investigate allegations of wrongdoing, and adoption of the Options
btudy 's foregoing recommendations will help to ensure that such investi-
gations are more extensive than are current cause examinations. More-
over, bROs nave a duty to determine, on the basis of sucn examinations,
wnetner tne tirm or its salespersons nave violated an bRO rule or
federal law, irrespective of the implications of such a determination
in any litigation against tne firm.

wmie, of course, situations may arise when the investigating
t>KO is unaule to maxe sucn a determination, as, for example, when a
customer refuses to talk to an bRO, such situations should not arise
1 recently.

Accordingly, the Options btudy recommends:

EACH bRO bHOUBD UbE DUE DILIGENCE TO ASCERTAIN
ALL RELEVANT EACTb BEFORE CLObING A CAUbE EXAMI-
NATION OR INVEbTIGATION WITHOUT ACTION AND
DEiERi-lINE WHETHER THERE lb A REAbONABLE LIKELIHOOD
THAT AN bRO RULE OR PROVIblON OF LAW HAS BEEN
VIOLATED.

bROs bHOULD EbTAbLIbH PROCEDUREb 'lO AbbURE THAT
AN INTERVIEW OR TEbTlMONY OE MEMBERb, bUPERVIbORb,
bALEbPERbONb AND OlHERb lb OBTAINED WHEN APPROPRIATE
IN bALEb PRACTICE CAUbE AND ROUfTNE EXAMINATIONb IN
ORDER TO DETERMINE WHEl'HER THERE MAY HAVE BEEN
A VIOLATION OE APPLICABLE LAWb OR RULEb, TO
Vi^RlEY INFORMATION OBTAINED FROM ANOIHER bOURCE,
OR lO REbOLVE DlbPUlBD IbbUEb OE FACT.

549

F. Inadequate resources

A final problem with SRO examinations and investigations is that
they are freauently undertaken without adequate committment of re-
sources bv the SRO. 68/

Senior options exchange officials have frequently suggested that
their SROs have not committed sufficient resources to their sales prac-
tice compliance programs. Instead, SRO resources have been committed
to market operations, and, in response to heavy inter-market competitive
pressures, to market promotion.

Manpower limitations have severely inhibited sales practice over-
sinht proarams. AMEX officials have noted, for example, that because
of limited manpower, the exchange staff was unable to complete its
routine examinations of member firms in 1975 and had to hire eleven
temporary examiners to catch up. In addition, because available man-
power at the AMEX is usually committed to routine examinations, cause
examinations of customer complaints and of registered representative
terminations are often delayed. At the OBOE, manpower limitations
caused that exchange to fail to complete its required inspections
durinq both 1976 and 1977. The exchange admitted that this failure
resulted from inadequate staffing of its inspections unit.

Manpower limitations generally force all the options exchanges
to send only one examiner to a firm to conduct a sales practice

68/ For a summary of SRO resources, see Appendix H.

550

examination. As a result, disputes regarding the examiner's factual
findinas may necessitate re-examination of the firm or acceptance of
the firm's representations. Finally, SRC compliance supervisors admit
that they do not routinely examine branch offices since such examinations
would place too great a strain on the SRG's limited sources. Similarly,
limited manpower has restricted the SROs' ability to conduct branch
office inspections in conjunction with cause examinations into customer
comolaints, terminations of salesmen for cause and similar Investigations
or inouiries that, in most instances, are conducted from the SRC's offices
without a visit to the subject firm or interviewing in person the registered
representative.
V. REMEDIAL ACTIONS

A Drimary objective of SRO disciplinary action is to cause member
firms and their registered representatives to cease improper conduct
and to initiate corrective action where necessary. In addition, disciplinary
sanctions serve a deterrent function both with respect to those disciplined
and to others. The Cot ions Study believes that the SRO disciplinary
orograms, as they relate to options sales practices, do not achieve these
objectives satisfactorily.

One reason for their ineffectiveness is that SRO investigations,
which orovide the factual basis for disciplinary actions, are often too
narrow in scope, are incomplete, or are conducted without the SRC hav-
ing access to all available information necessary to develop a proper

551

record. Implementation of the Options Study's reconnmendations including

the use and sharinq of compliance information should make SRC investi-

qations and fact finding more useful. But unless SRCs also impose

meaninqful sanctions on those who are found to have violated SRO rules,

their sales practice compliance proqrams will not achieve the required

objectives.

SRO disciplinary proceed inqs are too often ineffective in dealing

with violations of important options selling practice rules and in applying

appropriate sanctions for the following reasons:

The majority of formal disciplinary actions brought
bv SROs have involved primarily procedural rule
infractions.

SROs sometimes allow a firm repeatedly to
violate the same rules or related rules without
taking formal disciplinary action.

SROs do not limit the use of letters of caution or
other informal disciplinary sanctions to minor or
inadvertent rule violations, but sometimes use
these mild remedies to sanction aggravated rule
violations. And in some cases, where serious
violations are detected, no action - either formal
or informal — is taken.

A. Extent of formal disciplinary proceedings

As noted in Chapter V, the major options selling practice problems
involve suitability of recommendations made to customers, excessive
tradinq, abuse of discretionary accounts, misleading promotional
materials, and misrepresentations as to risk and return available
from listed options trading. Many of these problems have developed
because of inadequate screening of registered representatives and

552

inadequate supervision of these registered representatives by retail
brokerage firms.

Between 1973 and 1978, the SROs initiated at least 750 options
related disciplinary actions against retail firms and/or their
reqistered representatives charging sales practice violations. Chly
108 of these actions were formal proceedings. Despite the critical
importance of suitable recommendations to options customers, and
disturbing indications that suitability standards are being disregarded
formal SRO proceedings for suitability rule violations are rare (19 of
750) , as are those relating to fraud or to excessive trading problems
(8 of 750). Table VI below classifies, according to the nature
of the violation, the number of options related formal disciplinary
Droceedinqs which have been instituted by the various SROs.

553

TABLE VI

Options related Sales Practice Formal

Disciplinary Actions brought

by the SROs from 1973 through March, 1978

Total Number of
Disciplinary Actions

Violations Charged

No RDP

Failure to Use Due

Dil iqence to Learn Essential

Facts on Account Opening

Tradinq Prior to ROP Approval

Customer Account Agreements

No Prospectus Delivered

Inadeouate Supervision

Discretionary Trades Without
Written Authorization

unsuitable Recommendations

Misleading Promotional Materials

Failure to File Advertising

Excessive Trading

Embezellment, Conversion or
Use of Customer Funds

Forqerv

Fraud or Misrepresentation

Books & Records, Margin, Reg
T and Net Capital

Other

CBOE

NASD

PHLX

PSE

MSE NYSE
0 14

554

B. Use of informal sanctions

Instead of instituting formal disciplinary proceedings against a
person or firm found to have violated the stated SRO rules, an SRO
may choose to proceed against a respondent in a more informal manner ,
such as by issuing a "letter of caution," a "letter of education"
or a "letter of admonition". In deciding whether to take action and
what form the action should take, most SROs consider such factors as
the seriousness of the misconduct, the extent of injury to public
investors, any remedial action already taken by a firm and/or its
employees, and whether similar or related violations by the respondent
have been detected previously. Approximately 85 percent of all SRO
options related sales practice disciplinary actions initiated since
listed options trading commenced were resolved by informal sanctions.

The SROs assert that informal disciplinary actions generally are
reserved for only minor or inadvertent violations in which there was no
injury to public customers. The Options Study found, however, numerous
informal disciplinary actions in which various SROs apparently did not
adhere to this self-imposed standard.

Some letters of caution even characterize the conduct as "serious
violations of Exchange Rules." In one such situation, a letter of
caution noted that a firm failed to advise a customer of an exercise
assiqnment until "nearly one month after the option expired" and
concluded that the firm's actions were "not fair and equitable
in accordance with Exchange Rules."

The SROs also have issued repeated letters of caution to member
firms which have continued to engage in the same or similar rule viola-
tions for consecutive years, as illustrated by the experience of one
firm as set out in Table VII.

000

1975

1976

1977
1978

Table VII

Summary of Disciplinary Action
by an SRO Against Firm ABC

Type of Cot ions
Problem Detected

Inadequate or imrroper account
documentation; unsuitable trad-
inn or churning.

Inadequate or improper account
documentation; departure from
firm procedure manual regarding
option or other position infor-
mation.

Inadeouate or no suitability infor-
mation; inadequate or improper account
documentation; departure from firm pro-
cedure manuals regarding option or other
position limits; inadequate supervision
over discretionary accounts1 activity;
imrroper distribution of OCC prospectus
and amendments thereto.

Inadequate supervision or proof of super-
vision over discretionary accounts.

Inadeouate or improper account documen-
tation; inadequate supervision or proof
of supervision over discretionary ac-
counts; unsuitable trading or churning;

Action
Taken

Educational letter
sent to firm

Educational letter
sent to firm.

Five "educational letters" were sent to this firm, yet the problems
detected in 1974 persisted in 1978.

556

In another example, an SRO conducted an options selling practice
examination of a medium sized retail firm in 1975. The examination
disclosed several problems generally pertaining to the opening of options
accounts and account documentation. The firm was sent a letter of
caution. In 1976, the same SRO conducted a second options sales practice
examination and, according to the examination report, the "same violations
were found to exist [as existed in] the previous routine examination."
In view of "the serious nature of the violations uncovered," the SRO
held a "soecial interview" with the senior manager of the firm. During
the interview, the SRO staff warned that a " re-occur ence of any of
these rule violations could result in a formal disciplinary action."
A special options sales practice examination of the firm was conducted
a few months later. All of the firm's active options accounts were
reviewed and substantially the same violations were found again.
Nonetheless, the firm was sent only another letter of caution.

In deciding whether to initiate their own disciplinary action,
SROs also appear to give substantial deference to internal disciplinary
action previously administered by a member firm, which may or may not
be appropriate, dependinq upon the circumstances. In one situation,
a registered representative admitted to an SRO that he had exercised
discretionary authority over an account without written authorization
from the customer. During an eight week Deriod, due to this registered

00/

representative's handling of the account, the customer had lost $53,00G,
while the firm earned $9,000 in commissions. Because the firm had
censured the salesman and fined him $1,000, and because the customer
had already sued the firm, the SRO did not take any formal disciplinary
action but, instead, issued a letter of admonition to the registered
representative.

In another situation, a registered representative admitted that he
affixed the names of customers to certain documents including options
agreements. Che of these customers lost in excess of $20,000 as a
result of the salesman's unauthorized trading activity. Yet, because
the firm had already taken action against the registered representative
by fining him approximately $5,000 and suspending him from the firm
without nay for 30 days, the investigating SRO sent the salesman only
a letter of caution .

The Ootions Study's concern about the use of informal sanctions
by the SRCs stems not only from the recognition that these sanctions are
the mildest form of remedial action, but relates also to the fact
that such informal actions are not publicized in any manner. They
need not be reported to the Commission, 69/ and since the SROs do not

69/ As noted above, the "violations" on which such actions are
based have not been the subject of a formal adjudication and
therefore are not final and reportable "sanctions" within the
meaning of Section 19(d) of the Exchange Act. See pp. 14 - 15,
above.

558

announce the results of such actions, neither the Commission, other SROs,
nor the investinq public learn about the misconduct or of the identity
of the parties involved. Moreover, if a registered representative is
emploved at a firm other than the one where he committed the violation, the
new firm is usually not advised of the issuance of a letter of caution.

The mildness of the sanction plus the absence of publicity obviously
reduces the impact of informal actions as a deterrent to future infractions,
The lack of publication of informal actions also decreases the public
accountability of the self-regulatory process. Moreover, unlike formal
actions, an informal action does not result in an adjudicated finding
of culpability and, therefore, does not give rise to a record which some
SROs consider to be admissible in subsequent administrative or disciplinary
actions. 70/

Finally, the Options Study found one type of rule infraction for
which SROs seem reluctant to take any action or impose even informal
sanctions. These rule infractions involve SRO regulation of the options
promotional materials used by member firms. As noted in the Chapter V,
misleadinq or exaqqerated materials are too often used to promote options.
The followinq case illustrates the problem.

In late November, 1976, a larqe broker-dealer firm sent to two
SROs a proposed advertisement about an options seminar. The seminar
was described, amonq other thinqs, as a " [d] ramatic , illustrated

70/ At the EHLX and AMEX, however, prior letters of caution are
sometimes acknowledged in decisions in formal disciplinary
actions.

559

course for both Men and Women" which, in "simple, nontechnical
larauaoe", would "answer Questions like..."

"How can option writers receive 20-40%
annual Dremium on their stocks?"; and

"Why does a call buyer have limited risk
but unlimited profit potential?"

Both SROs objected to the use of the term "dramatic", to the
reference to sDecified percentage gains, and to the "question"
about limited risk but unlimited profit potential. In accordance
with their Drocedures, both SROs edited the copy to remove or re-
phrase the unacceptable passages and then approved the advertise-
ment for use with the appropriate changes.

Fbur months later, in April 1977, a member of the public
complained to one of these SROs about the "gross misrepresentation"
and "misleading information" contained in a seminar invitation from
the same broker-dealer firm. The format of the invitation received
bv this investor was different from the November 1976 advertisement
(which the SROs had edited), but much of the language — including
that previously stricken as offensive by both SROs — remained
virtually unchanged. The SRO again revised the language,
and reouested an explanation from the firm as to why the mailer
was used without prior clearance. (The SRO did not mention that
much of the language had not only not been cleared by it, but had been

560

plainly rejected several months earlier.) The firm, in response,
blamed a "local oversiqht" for use of the mailer, and the matter
seemed closed.

Three months later , however , the firm again submitted to these
two SROs proposed invitations for a seminar. The format and language
were identical to the second (April 1977) version of the invitation.
For a third time, the SRO edited out the same offensive language.
No disciplinary action was taken against the firm.

In order to improve the effectiveness of SRO disciplinary
proceed inqs and the accountability of the self-regulatory process
the Ootions Study recommends:

EACH SRO SHOULD RESTRICT INFORMAL DISCIPLINARY
ACTIONS TO THOSE CASES INVOLVING MINOR, ISOLATED
VIOLATIONS THAT DO NOT INVOLVE INJURY TO PUBLIC
CUSTOMERS.

EACH SRO SHOULD ADOPT A POLICY WHEREBY A COPY OF
EACH LETTER OF CAUTION OR OTHER DOCUMENT NOTING
AN INFORMAL DISCIPLINARY ACTION IS SENT TO THE
CURRENT EMPLOYER OF THE REGISTERED REPRESENTATIVE
AND TO THE FIRM WHICH EMPLOYED HIM AT THE TIME
OF THE VIOLATION.

THE COMMISSION SHOULD ADOPT A RULE WHICH REQUIRES
SROs TO NOTIFY THE COMMISSION OF ALL INFORMAL
REMEDIAL ACTIONS. 71/

71/ In 1963, the Special Study of the Securities Markets made a

similar recommendation. Special Study Report, Pt. IV, pp. 577,
682.

561

c. Reasons for inadequate sanctions - restrictive SRO policies
The shortcomings of SRO disciplinary sanctions can be attributed
at least in part to certain restrictive SRO policies or practices.
Some SROs, for instance, follow a practice of maintaining strict
consistency in the sanctions imposed upon violations of identical or
similar rules. Thus, for example, if an SRO fined a firm $1,000 in
1975 for sales practices violations, similar violations in 1978
bv another retail firm likely would result in a similar fine. This
oractice does not recognize that, after five years of listed options
trading and numerous examinations by SROs, retail firms should now
be expected to understand and comply with SRO options rules. Fines
also may not take into account the relationship between the cost
of the fine and the profitability of the improper conduct. Seme firms
mav find it more economical to pay an occasional predictable fine
than to incur the expense of corrective action. 72/

The SROs also follow a policy of permitting a certain level of
rule violations to exist at a firm, because, in their view, it is
imrossible for a firm to comply with all SRO rules and applicable
laws. These SRO officials assert that what is important is that the
level of violations remains "manageable" in the sense that the number

72/ An official at one SRO informed the Options Study that, during
the "early" vears of listed options trading, member firms were
reluctant to undertake remedial action because they were uncertain
whether options commissions would be sufficient to defray the
compliance exDenses.

562

of violations, when compared to the size of the firm's total options
business, is "reasonable." As a result, many SRO compliance personnel
believe that no disciplinary action should be taken so long as the
number of customer accounts with record-keeping defects (for example,
no options agreement, no ROP approval, no essential customer information)
does not exceed a tolerable oercentage of a test sample of the firm's
accounts. The Options Study's review of the routine SRO examinations
which resulted in informal disciplinary action revealed that the
"manaqeable" level often appears to be between 10 and 15 percent of
the accounts sampled.

SROs are also lenient towards firms that appear to be trying
to remedy violations, often irrespective of whether real progress is
being made. For example, one senior SRO compliance official stated
that if he examined a firm one year and found 40 percent of the option
accounts not to have been approved by a ROP, and the following year
the figure was reduced to 30 percent, he would not recommend formal
disciplinary action because it would be apparent that the firm was
takinq effective remedial steps. According to this individual, "so
lona as the firm is not falling behind," that is, the scope of the
violations is not increasing, he would recommend that only a letter
of caution be sent to the firm.

The Options Study also found that one SRO restricts the coverage
of future proceedings if there has been a prior disciplinary action
cover inq the same subject matter. Between April and June 1976,

563

for example, this SRO conducted a sales practice examination of a

large national firm which uncovered numerous violations of the SRO's

rules relatinq to the opening of new accounts and failure of the firm

to exercise due diliqence to obtain essential customer information.

In November, 1976, the firm received a letter of caution. During this

oeriod, in Auaust, 1976, the SRO received a complaint from a customer

of the firm who alleged that a registered representative had executed

transactions without the customer's authorization and that the

customer had never executed a new account card. This complaint was

not investigated as oart of the proceeding then in preparation, but

was investiaated separately and at a slower Dace. The investigation

eventually established that indeed the customer had not executed an

ootions agreement until approximately four months after the initial

oDtions transaction, that his new account card "did not contain any

information concerning [his] investment objectives", and that the customer

had lost $14,200 in 10 months. Ultimately, the SRO staff recommended

that:

since the violation noted in this investigation
related to the violation [previously] noted . . .
for which the firm was issued a letter of caution . . .
no new action [should] be taken . . .

This practice may be inconsistent with the SRO's statutory

obliqations, particularly if a violation is serious or recurrent.

564

u. bKQ interned, supervision

wan/ routine examination files reviewed by the Options Study did
not contain adequate documentation regarding the procedures followed
in the examination and the findings of the examiner. In addition,
disciplinary boards of bKOs and senior administrative SHO officials
are not always apprised of all relevant data in the SROs' files per-
taining to a routine or cause examination. Sometimes, even the
important decision whetner to bring an action is left to the discretion
ot tne SKO investigative staff, rather tnan to a committee of members
or senior statf officials. 73/ In such instances cases are closed without
proper review. At some StfDs, supervisory procedures are inadequate
co detect sucn situations. Moreover, many cases involving apparent
violations are closed or informal disciplinary actions initiated
witnout any documentation stating the underlying reasons for such
action. Tne aosence of written records makes effective supervision
very ditticult.

73/ See Cnapter IV.

565

accord ingly, tne Options study recommends:

EACH bKD SHOULD RETAIN A RECORD OF THE RESULTS
UF EACH ROUTINE OR CAUSE EXAMINATION, WHICH
SETS tUKTH REASONS WHY NO ACTION WAS TAKEN
WHEN APPAREN1 VIOLATIONS WERE DETECTED OR WHY
ONLY INFORMAL DISCIPLINARY ACTION WAS INITIATED,
AND THAI SUCH RECORDS dE REVIEWED PERIODICALLY
BY THE SRO'S GOVERNING BOARD OR COMMITTEE. 74/

E. restitution as a sanction.

a public investor wno sustains an injury due to tne misconduct
ot a salesman or ms tirm must generally resort to litigation or
aroitration to recover nis losses, although, at tunes, a firm may pay
carnages to a customer in anticipation that this action will be taken
into consideration oy an SRO in deciding whether to take disciplinary
action or in imposing sanctions. In many instances, litigation is
exjjensive and impractical ror tne customer, 75/ and arbitration, wnile
soniewnat less expensive, is trequently time consuming and inconvenient.
Skus do not order restitution to injured investors as a sanction
in a formal disciplinary action, primarily because they believe that
cney oo not nave tne autnority to do so.

wnere an Sro nas already conducted an investigation and decided
to institute tormal disciplinary action, a public investor harmed
oy tne conduct wnicn torms tne basis for tne disciplinary action
snouid not nave to duplicate tne SRO's work and proceed in another
to rum. Several senior SRO staff members concede that tne power

74/ See recommendation in Cnapter IV with respect to AMEX investiga-
tion and enrorcement.

75/ See Report from the Office ot Consumer Affairs to tne
Commission, December, 1976, pp. 1-24 - 1-31.

566

to order restitution would be a strong incentive for retail
firms and their salesmen to initiate meaningful remedial action
or refrain from abusive practices. As one SRO official stated:
"I wish we had that tool in our bag."

Recent amendments to the Exchange Act permit all SROs
to impose "any fitting sanction," including restitution. 76/
To the extent, however, that an SRO, by rule, has restricted the
scope of sanctions which it may impose, for example, to expulsion or
suspension from membership or association with a member, a censure,
or a fine, such rules would have to be amended to permit the SRO to
award restitution.

Accordinqlv, the Options Study recommends:

EACH SRO SHOULD AMEND ITS RULES IN ORDER SPECI-
FICALLY TO PERMIT THE AWARD OF RESTITUTION
AS A DISCIPLINARY SANCTION, WHENEVER SUCH A
SANCTION WOULD BE APPROPRIATE.

F. SRO disciplinary proceedings: a final note
SRO disciplinary efforts with regard to options selling prac-
tices have been largely ineffective for the reasons discussed above.
Manv oroblems may be remedied by revising SRO rules and procedures.

Of more concern to the Options Study, however, was a prevailing
ohilosophy at some SROs that options rules are "new," and thus member
firms, their supervisors and registered representatives should be

76/ Report of the Sentate Comm. on Banking, Housing and Urban
Affairs to Accompany S.299, S. Rep. No. 94-75, 94th Cong.,
1st. Sess. 96 (1975) .

567

"educated" as to their responsibilities before strong enforcement action

is taken. The application of this philosophy, which still prevails, has

been reflected in lax enforcement programs against selling abuses and

a system of sanctions where the letter of caution is considered severe.

Such a philosophy is inconsistent with the protection of public

investors, and the Commission has explicitly rejected it in the context

of sales practices of retail firms:

The duty of supervision cannot be avoided
by oointing to the difficulties involved where
facilities are expanding or by placing the blame
upon inexperienced personnel or by citing the
pressures inherent in competition for new
business. These factors only increase the
necessity for vigorous effort. 77/

The Options Study believes that the Commission's statement

is particularly applicable to the initiation and rapid growth of

the options markets where SDecial dangers to the unsophisticated

or unwary investor are present.

VI. THE NEED FOR MINIMUM SRO COMPLIANCE STANDARDS

Each SRO has designed and implemented its own compliance
programs. As discussed throughout this chapter , the resulting
combined SRC svstem has many inconsistencies and voids. Compliance
nroqrams, including examination and disciplinary programs, differ

77/ In the Matter of Reynolds & Co . , Securities Exchange Act Release
No. 6273 (Mav 25, 1960).

568

anong SROs both as to their fundamental objectives and as to each
SRO's ability to acquire and effectively use relevant compliance
information. These differences have adversely affected the ability
of the self-regulatory organizations to oversee the conduct of member
firms and their employees. Although SROs are increasingly allocating
resDonsibilities amonq themselves in order to eliminate duplicative
Droarams and minimize operating expenses, no effective steps have
been taken by the SROs to ensure that each SRO's program conforms to
minimum standards of performance. Moreover, in those areas where
the SROs have not allocated responsibility, increased coordination
and cooperation is needed to assure more effective and efficient
compliance proqrams among SROs.

The current differences in performance and the absence of mini-
mum standards can significantly impair the SROs' continued willingness
to expand their allocation and coordination efforts. The Options
Study's concern in this regard was raised with the Self -Regulatory
Conference, which agreed to develop "a more standardized compliance
prooram." The Conference also agreed that "it should be possible
to establish some industrv-wide objectives for the conduct of a
[broker -dealer] examination so as to insure the protection of inves-
tors, avoid regulatory duplication, and eliminate regulatory voids." 78/

78/ Appendix E, letter to Richard Teberg, Director, Special Study of
the Options Markets from the Self -Regulatory Conference, dated
October 6, 1978 at p. 7.

569

Moreover, the Conference stated that "existing programs may be refined
so as to increase their comprehensiveness and to facilitate their
use, as deemed appropriate by each SRO."

While the Cot ions Study is recommending that the SROs establish
minimum standards, it does not recommend the establishment of uniform
standards. Che of the basic strengths of self-regulation has
been the opportunity for innovation and fresh initiatives. The
development of minimum standards should not be permitted to impair
imaqinative solutions to better protect the public.

The Ootions Study supports the Conference's undertaking and

recommends :

SROs SHOULD DEVELOP STANDARDS FOR THE ESTABLISHMENT
OF MINIMUM CCMPLLANCE PROGRAMS FOR IMPLEMENTATION BY
EACH SRO; THE PROGRAMS SHOULD PROVIDE INDUSTRY-WIDE
OBJECTIVES FOR THE MONITORING, EXAMINATION AND
DISCIPLINARY PROGRAMS OF THE SROs AND PROVIDE
STANDARDS BY WHICH THE SUCCESS OF THE PROGRAMS
WOULD BE MEASURED.

570

EXHIBITS TO CHAPTER VI

APPENDIX D
Summary of SRO Options Related Examinations and Investigations
of Firm DEF for 1973 - 1978

Between 1973 and 1978, the SROs collectively conducted 32 options
related examinations and inquiries of this firm and/or its registered
reDresentatives. The results of these inquiries are summarized below.

As this summary demonstrates, the SROs, through their extensive
inouiries, should have had a comprehensive picture of the operations
and sales practice procedures of this firm, which, since 1973, has
had increasing sales practice problems. The disciplinary action taken
to date by the SROs, however, is not consistent with the firm's
total conduct.

This chart also substantiates the Options Study's conclusion
that none of the SROs is aware of this firm's compliance history.
This is directlv attributable to the fact that SROs do not exchange
relevant ccmDliance data.

Moreover , the sanctions imposed by SROs have been ineffective in
deterrina violations by the firm, as evidenced by the Commission's
administrative proceeding in 1978.

571

SRO Examinations and Investigations of firm

DATE

6/73

SRO

NYSE

10/73 NYSE

DEF

for

1973-1978 *

TYPE OF

FINDINGS OR

EXAMINATION

ALLEGATIONS

DISPOSITION

Routine

No options related
problems detected

No action **

Cause

Improper recon-
cilation of options
suspense accounts

Letter of edi

12/74 NYSE

Rout ine

No options related
or obi ems detected

No action

12/74 NASD Cause

Misrepresent-
ation

No action

12/74 NASD Cause

Unauthorized trades,
false quotations;
RR admitted
several errors

Firm censured and
assessed costs

2/75 NASD Routine

No options related
problems detected

No action

2/75 NASD Cause

Improper handling
of account; "in-
consistent" recom-
mendations to cus-
tomer

No action

This chart was prepared from summaries of SRO examinations
furnished to the Options Study by the SROs. In some instances,
an SRO failed to furnish certain information, as noted in the
chart.

No action means that the matter was closed without formal or
informal disciplinary action because, in general, the investi-
qating SRO did not find an apparent violation or there were
disputed issues of fact which the SRO did not resolve.

572

Inadequate or unpro-
-vxmt docu-
t ion; inadequate
super, .^ure
to verity contract
leconcile

one to uti^ .

tion procedure a
proved Dy tne ft

Deterreo to CBOE
(See b/75 caot:
routine examin-
ation oelow)

15c3-l

Verbal caution

Accounts \: ap-

proved Dy «QP in
reasonanle time;
. customer
aqreemer.t^ • EailUEE
to use due dili-
gence in opening
accounts

Fined - $10,000

.- -

No options :
prooiems det

No action

U :

personnel;
inadequate or im-
proper account do-
;■_ entation

Letter of education

573

TYPt, OF
EXAMINATION

FINDINGS OK
ALLEGATIONS

DISPOSTION

lz/7b

Cause

Unsuitaole trading

Admonitory letter

6/ 'lb

Cause

Inadequate
margin in custo-
mer accounts;
unsuitable recom-
mendations; un-
authorized trades

No action

b/7b CdoE

Accounts not ap-
proved by ROP
in reasonable
time; trading
prior to ROP ap-
proval

Staff interview

iu/7b NYbE

Unqualified super-
visory personnel;
inadequate or im-
proper account do-
cumentation; in-
adequate supervi-
sion

Letter of
education

iu/7b NYSE

Unauthorized trans -
act ions ; inaaequa te
margin

Pending

574

TYPE UF
EXAMINATION

FINDINGS OR
ALLEGATIONS

DISPOSITION

11/ 7b CBOE

Improper handling of
account; failure to
explain risks of
trading; account not
approved for options
trading

No action

1/77

CtsOE

Excessive trans-
actions; unautho-
rized transactions;
unsuitable trans-
actions; failure
to supervise

Excessive trades;
unsuitable recom-
mendation; failure
to supervise

Censure
and fined
$2,500

Censure
and fined
$5,000

V77

NYSE

(Information not
furnished )

No action

2./11

NASD

Excessive trading;
unsuitable recom-
mendations

No action

b/77

Al'lEX

Inadequate or im-
proper account
documentation; in-
complete customer
conf irmat ions ; un-
qualified super-
visory personnel

Letter of
caution

6/77

Excessive trading

No action

575

DATE

SKD

type of

EXAMINATION

FINDING UK
ALLEGATIONS

DISPOSITION

b//7

Cause

Excessive trading

Deferred to
NYSE

7/77

Disagreement with
customer

No action

7/77

(Information not
furnished)

"Resolved by
CbOE"

7/77

Ml-lEX

Cause

Disagreement with
customer

No action

y/77

M isappropr iated
funds from
customer ac-
count; conver-
sion of customer
securities; un-
authorized trans-
actions

Charges filed-
case open

1U/77

No options related
problems detected

No action

12/77

Permitted options
to expire without
being exercised

No action

J/78

Inadequate dis-
closure of risks;
unsuitable recom-
mendations; mis-
representation

Pending

576

SKO

TYPE Of
EXAMINATION

FINDINGS OR
ALLEGATIONS

DISPOSITION

4/78

N¥bE

Excessive trading;
unsuitable trans-
actions

No action due
to CBOE action

7/78

Unauthorized trades;
unsuitable recom-
mendations

Pending

In 1978, the Commission concluded its own investigations of two branch
ortices or tins firm. Commission investigators discovered numerous incidents
or unsuitable recommendations, excessive trading, unauthorized transactions,
option accounts tradiny prior to KOP approval, inadequate supervision, and
various misrepresentations, particularly with regard to the risks of options
trading. As a result of these violations, the firm agreed to make improvements
in its compliance and supervisory procedures, and to reimburse certain customer
accounts in a total amount exceeding $2U0,0UU.

577

APPENDIX E

Mr. Richard Teberg , Director October 6, 1978

Special Study of the Options Markets
Securities and Exchange Commission
500 North Capitol Street
Washington, D.C. 20549

Dear Mr. Teberg:

Preliminary Statement

As you are aware, during August, 197B, the staff of the
Options Study held several meetings with representatives
of the following organizations: American Stock Ex-
change, Boston Stock Exchange, Chicago Board Options
Exchange, Midvest Stock Exchange, National Associa-
tion of Securities Dealers, New York Stock Exchange,
Options Clearing Corporation, Pacific Stock Exchange,
and Philadelphia Stock Exchange (hereinafter participant
SRO's or the group). Also participating were represen-
tatives of the Commission's Divisions of Enforcement,
Market Regulation and Consumer Affairs, and Monchik-Weber
Associates, Inc. These discussions described the Com-
mission's concerns which precipitated the request for
a Proposal For A Ilarket Surveillance System as awarded
to Mcnchik-Meber Associates, Inc. as well as the pre-
liminary findings of the Options Study which indicate
the need for areater coordination of exist inq option::
and- securities regulatory system so as ' to achieve
an integrated industry-wide regulatory system.

578

Mr. Richard Teberg Page Two

The meetings of the participants have focused upon the
need for the creation of an integrated regulatory system
among the SRO's which would enhance total industry regu-
latory capability by coordinating and interfacing exist-
ing regulatory data and programs through the sharing of
available information/ improvement of regulatory tech-
niques, the allocation of regulatory responsibility and
the centralization of registration data and customer com-
plaints to facilitate access.

In particular, the Options Study has noted several areas
of concern which are indicative of its findings and which
should be addressed in order, in its opinion, to im-
prove overall regulatory capability of the SRO's. The
main objectives would be to eliminate overlapping ef-
forts which may presently exist, to fill existing voids
in regulatory programs and to promote the interchange
of and access to information. This is especially true
with respect to dual trading in options and stocks and
intermarket options activities. These concerns center
upon whether there is a need for the SRO's to:

(1) share and improve existing data bases and in-
crease inter and intra-market cooperation;

(2) to enhance audit trails to promote intermar ket
reconstruction and surveillance;

(3) enhance regulation of off-floor proprietary
and customer accounts;

(4) establish audit trails for position adjust-
ments, "as of" transactions and Clearing
Member Trade Assignment arrangements;

(5) establish minimum uniform standards which
trigger surveillance follow-up activity;

(7) receive and process relevant information from
each SRO regarding registered personnel and
to utilize such in preparation for regulatory
examinations and investigations;

579

Mr. Richard Teberg Page Three

(8) conduct more examinations of member firms which
may incorporate regulatory methods and practices
which have not been routinely utilized by all
SRO's in the past;

(9) establish the method, form, and principles
upon which information available lo one or
more SRO's will be accessed by other SRO's;
and

(10) establish uniform minimum compliance and dis-
ciplinary programs.

The Options Study also recognized the importance of
enhancing regulation of broker-dealers who, though
not a member of an options exchange engage in ex-
change listed options activity by going through a
clearing member (so called "access firm"). How-
ever, this problem appears to be nearing resolution
by the Commission's recent conditional approval of
the NASD's "access" rule proposals. This situation
would be further improved if the SEC would now adopt
and approve comparable rules to regulate SECO and
other broker-dealers not covered by the rules governing
access firms or any other specialized options rules.

Although it is recognized by the participant SRO's

that complete integration of regulatory information

and systems may present technical and feasibility

questions, it is acknowledged that the establishment

of a more fully integrated regulatory system is

both necessary and desirable as a means of establishing

more efficient and effective regulation which may

be cost-effective to the industry and achieve minimum

standards of regulation on an industry-wide basis

thus assuring the protection of public investors.

Significant progress has been made by the participants
toward the creation of an integrated regulatory system.
Numerous meetings and discussions have been held by the
group and sub-groups formed for the purpose of focusing
on specific issues including (a) interchange of market
surveillance information, (b) interchange of compliance
information ' relat ing to firm- examinations and sales
practices, (c) development of central files for regis-
tered personnel and customer complaints, (d) allocation
of regulatory responsibilities, and (e) legal matters
to be addressed in order to achieve an integrated
regulatory system.

580

Mr. Richard Tebcrg Page Four

As a result of these discussions, the participant
SRO's listed above met jointly for the purpose of
defining the overall parameters of a comprehensive
regulatory system based upon their complete and
thorough understanding of the capabilities presently
in place and, following such analysis, to make recom-
mendations for the implementation of the system.

The group, based upon the reports and recommendations
of its sub-groups, and its own deliberations to date,
has achieved agreement in several specific areas
and wishes to submit this preliminary report to apprise
the Options Study of the material developments which
have occurred and to focus attention on those areas
which, although approved in principle by the various
SRO's, remain to be fully resolved before considera-
tion may be given to their later implementation. It
is clear, however, that continuing efforts will be
required in order to reach mutually satisfactory solu-
tions and that further meetings of the SRO's with
the Commission's staff will also be required to
facilitate the implementation of desired programs.

I. Interchange of Market Surveillance Information

A sub-group was established on interchange of Market
Surveillance information. This body was directed
to identify all market surveillance reports and
information presently availaole to each participant
SRO in order to determine which information could
be integrated into other self-regulatory organizations'
programs to enhance existing regulatory efforts with
respect to intermarket surveillance. This sub-group
thereafter collected from and furnished to each par-
ticipant SRO, including the Options Clearing Corpor-
ation, copies of all option and equity computer
print-outs and certain manually prepared reports
(along with explanatory materials identifying the
type of data, format, frequency and purpose) which
are utilized in conducting market surveillance for
listed securities. In addition to disseminating
examples of data base information derived from
transaction and clearing streams, each organiza-
tion provided copies of reports which identify
activity which exceeds pre-determined parameters
during a trading session.

After the analysis of this voluminous information,
a better understand ing of the nature of information
available '.-as achieved. There was also* a consensus
that the sharinq of data by the various SRO's is
both needed and desired. However, while certain
acreements have been reached, it is yet to be def.-r-

581

Mr. Richard Teberg Page Five

It is generally agreed that any information inter-
changed may be more desirable in a computer readable
format rather than on microfiche or hard copy print-
outs for manageability and flexibility purposes.

Further, it is noted that certain data which would
be useful to each organization is presently avail-
able on an or.-line basis through such systems as the
OTIS system for collecting and displaying option in-
formation and for stock activity from the last sale
and quote information transmitted via High speed
lines. This information may be captured with ap-
propriate programming which is being explored.

During a general discussion of the adequacy of option
and stock data bases and audit trails, it became ap-
parent that a significant difficulty in an effective
and efficient integrated system is the reconstruction
of transaction data on the underlying security in a
form which identified the broker/dealers involved in
each transaction and whether they are acting as agent
or principal. Various participants expressed concern that
such a system might be very expensive to construct and
maintain and that these costs must be weighed.

After identifying the information available, the part-
icipant SRO * s expressed interest in the exchange of
market surveillance information as follows:

a) Reconciliation Clearing Sheets from markets where
securities underlying options are traded.

b) Daily Transaction Journal from all markets where
securities underlying options are traded.

c) Monthly Short Interest Reports by firm from all
markets where securities underlying options are
traded .

d) Block trade reports from all markets where securi-
ties and options are traded.

e) Notification of the initiation of investigations and
reviews, as appropriate.

f) Status reports on investigations and reviews, as ap-
propriate.

g) Notification of trading halts.

582

Mr. Richard Teberg Page Six

h) Notification of corporate contacts resulting from
unusual trading activity.

i) Exercise/Assignment Listing Reports from OCC.

j) Open Interest Distribution Reports from OCC.

k) Market Data Retrieval Reports and Matched Trade
Listing Reports.

The equity exchanges indicated that they would be
responsive to inquiries by the options exchanges with
respect to matters which could affect trading in under-
lying securities and options trading thereon and would
make every effort to inform other appropriate market
centers of trading halts.

With respect to the interchange of information per-
taining to multiply listed options, we believe that
useful data is currently being disseminated to the
options exchanges via the daily Cptions Clearing
Corporation compliance tape and that modifications
due to be implemented in the beainning of 1979 will
enhance monitoring capanilitiBS oy providing member
transactions in multiply traded classes executed on
other exchanges. These modifications, as currently
envisioned will consist of each participant SRC re-
ceiving the following:

a) All positions, exercises/assignments and ad-
justments of their members regardless of
where the options class is listed;

b) All cleared options transactions of their
market makers/specialists/registered traders;
and

c) All exercises, assignments, positions and adjust-
ments of non-members trading in classes which
are solely listed on their exchange.

There is general agreement among the participant SRO's
that they are willing to share information for surveil-
lance purposes subject to certain specific limitations,
i.e. non-member specialist and marketmaker positions
which would be . provided on a case-by-case basis rather
than as a matter of routine. It is important to note
that the participant SRO's agree- that all information
would be available to other SKO's for specific investi-
gat ions.

583

Mr. Richard Teberg Page Seven

It was suggested that rather than receive information
from each option exchange the Options Clearing Corpor1-
ation upon appropriate authorization could furnish a
modified daily compliance tape to non-OCC participant
SRO's which would contain the information requested
except for data pertaining to non-member specialists,
traders, and mar ketmakeis.

The group recognizes that there could be problems in-
herent in providing an SRO information .pertaining to
a non-neraber of that participant. It remains to be re-
solved whether such information is to be furnished on
a routine basis or only upon request.

With respect to the legal question of providing a par-
ticipant with information pertaining to a non-member,
the legal suo-group raised questions of legal liability.
It believes, however, the potential liability of SRO's
would be decreased if the action taken (a) is pursuant
to legitimate regulatory objectives under the Securities
Exchange Act of 1934 and does not involve excessive or
gratuitous compromise of privacy or due process rights;
(b) has been duly authorized by the SRO's and approved
by the SEC; and (c) each SRO has implemented appropriate
rule changes to the extent necessary and/or has required
proper disclosure.

II. Compliance Plan for Member Firm Examinations and
Information Saar ma

■ r

We established a sub-group to review current industry
compliance practices toward the goal of developing a
more standardized compliance program. This program would
utilize in part the concept of a central reporting of
relevant information concerning member firms. The aims
of such a program would be, among others, to promote
a sharing of relevant information about broker/dealer
compliance activities and to assist in the execution
of complete, comprehensive and thorough examinations
of such firms. In addition, the group agrees with the
Options Study that it should be possible to establish
some industry-widci objectives for the conduct of an
examination so as to insure the protection of investor:: ,
avoid regulatory duplication, and eliminate regulatory
voids.

It is agreed that a broad "Compliance Plan" would include

I. Continual Monitor mc Programs

II. Spccicl Attentior Pronr^iiis

III. Examination Proorcns

IV. Disciplinary Prourame

v. hdu rational Programs

584

Mr. Richard Teberg Page Eight

While we acknowledge that most, if not all, of the
basic components of the programs noted above are in
place and presently being utilized by one or more
of the SRO's, it is also agreed that certain of these
programs may have to be further refined so as to
increase their comprehensiveness and to facilitate
their use, as deemed appropriate, by each SRO.

In addition to the above, we have agreed that the com-
pliance plan sub-group should include within the scope
of its discussions matters such as:

the targeting of, and visits to, branch offices
for examinations;

the enhancement of examination "audit
trails;"

the uses of "intelligence" information re-
ceived frcm other SRO's; and,

a comprehensive pre-exaraination procedure.

III. Centralization of Compliance Data for Registra-
tion and Investigation Purposes

We established a sub-group to review the feasibility
and usefulness of creating a central repository for
compliance information. .As a result of the sub-group's
recommendation we have determined that a repository
could be utilized to provide each self-regulatory
organization with more information than is presently
utilized for purposes of registration of personnel,
customer complaints, investigations and examinations.
We also believe that measures should be taken in
this area to decrease or eliminate duplication of
efforts r.mong self-regulatory organizations and in-
crease the overall efficiency of such processes
within the industry. The group further agrees that
the adoption of these measures should not, to the
extent feasible, result in increased costs to the
industry.

585

Mr . Richard Teberg Page Nine

The NYSE offered to become the central repository for
general compliance information for thos"e firms for
which it is the designated examining authority. The
NASD offered to include data elements relating to
customer complaint information on its automated system
for processing registered representative applications.
Such system presently contains certain data elements
of interest to the sub-group including termination
for cause information and final disciplinary actions
taken against registered personnel. Each SRO agreed
to furnish the NASD with output requirements they
would need from such central repository system with
the understanding that the NASD will outline for con-
sideration a system designed to meet their needs.

To date there has been no general agreement as to how
information could be used except to provide "intel-
ligence0 for SRO's preparing for examinations and
investigations. There was concern as to potential
legal obstacles which could prevent information
sharing, however, we have concluded that potential
legal liabilities v.'ould be reduced if the procedure
outlined on page 7 is pursued.

The group has agreed that, aside from the feasibility
of such a plan, a central file on registered personnel
which would include at least all information regard-
ing registration and termination, customer complaints,
and formal actions taken by SRO's and other regulatory
bodies would be a worthwhile accomplishment. It is
generally agreed that such information would assist
each participant in determining whether registration
was appropriate, whether closer than normal surveillance
was warranted and would provide information useful in
the preparation and conduct of investigations and ex-
aminations. ...

Additional questions were raised concerning access
to such information and whether or not such a re-
pository would include matters which have not yet
reacred a conclusive state at a reoulatory body.
Representatives on the sub-arouo have agreed to review
the position of their organization with regard to the
sharing of this infotmation keeping in mind the goal

586
Mr. Richard Teberg Page Ten

IV. Allocation of Responsibility

We established an allocation of responsibility sub-
group to explore the means of identifying and elimin-
ating duplicative regulatory efforts as well as the
measures necessary to improve regulatory programs.
The sub group was also requested to provide the means of
resolving such overlaps and shortfalls through the
allocation of responsibility for investigation and
enforcement and to assure, as much as possible, the
uniform interpretation and application of comparable
self-reaulatory and Commission rules. The group focused
on problems involving jurisdictional issues where
membership in more than one self-regulatory organiz-
ation existed and on inter-market trading activities
which transcended individual SRO jurisdictional
boundaries, such as insider trading activities,
fraudulent and manipulative trading practices, tape
racing, front-running, expiration studies and other
specific inter-market transactions.

For purposes of its discussions, the participants
determined that non-member broKer-dealers and non-
member broker-dealer customers would be treated as
the same type of entity for surveillance purposes.
It was also determined that where a non-member
(whether a broker-dealer or customer) effects a
transaction using the facilities of a member bro-
ker-dealer, the matter should be referred to the
SRC that has jurisdiction over that non-member
or to the SEC if a non broker-dealer customer is
involved .

Of course, questions of jurisdiction over a broker-
dealer which is a member of more than one self-regulatory
organization and/or when a security is multiply traded
encompass much broader and complex issues and conse-
quently consumed a siqnificant portion of the aroup's
efforts. Based upon its discussions, the group
agreed to consider the following principles of allo-
cation:

587

Mr. Richard Teberg Page Eleven

(1) The surveillance end regulation of specialists, ■
market-makers and registered floor traders will
be retained by the self-regulatory organiza-
tions of which they are a member and on which
they fulfill such functions.

(2) The gathering of customer and firm information
needed in pursuing insider trading, and manipulation
cases shall be allocated to the primary market in
that family of markets whenever there is a dually
traded security.

(3) Whenever an SRO conducting an investigation lacks
jurisdiction over a broker-dealer non-member,

the information necessary to conduct the inves-
tigation shall be obtained from any other self-
regulatory organization of which such non-member
is a member.

(4) Expiration Studios - It was agreed that the SRO's
would inform each other when they are preparing
to conduct expiration studies of options vs.
stocks in order to prevent a duplication of ef-
fort. If two or more self-regulatory organizations

•have decided to perform a similar study, they would
determine among themselves which would conduct the
study? however, where market-makers, specialists
and registered floor traders are involved, the
self-regulatory organizations of which they are
a member shall retain responsibility for inves-
tigating such matters.

(6) Employees of SRO's will be made available for
testimony as needed by other SRO's in any case
where their testimony is required or where
such employees performed a portion of an inves-
tigation or examination. (The self-regulatory
organizations will continue to review the pos-
sibility of requiring their members to testify

at disciplinary hcarinqs of other self-regulatory
organizations which lack jurisdictional authority
over such members.)

588

Mr. Richard Teberg Page Twelve

In agreeing to these principles of allocation, we note
that certain initiatives in these areas have previously
been undertaken in the form of 17d-2 agreements which
have been entered into by the various participants and
filed with the SEC. We urge the Commission to promptly
review and act upon those agreements which it has not
yet considered. In doing so, we recognize that they
are not all inclusive in respect to the matters which
are the subject of our discussions and that amendment
of the 17d-2 agreements may be appropriate as these
matters are implemented.

To accomplish our goals, it is anticipated that there
will be further discussion by the participants to
allocate additional responsibilities with respect to
matters arising from inter-market regulatory prob-
lems and to further eliminate regulatory duplication.

The above presentation is a summary of principles
agreed upon by staff representatives of the participant
SRO's and those guestions remaining to be resolved
prior to achieving our objective of establishing
an efficient and effective integrated inter-market
regulatory system. We are continuing to meet in an
effort to achieve such a system. It must be borne
in mind, however, that certain aspects of these
programs would require formal action by the governing
bodies of the respective SRO's. Continued cooperation
on behalf of the SEC will, of course, be necessary
in order to achieve and implement these goals.

We welcome the Commission's participation at future
meetings.

Very truly yours.

American Stock' Exchange

Boston Exchange Exchange

589
Mr. Richard Teberg Page Thirteen

Chicago Board Options Exchange

Midwest Stock Exchange

National Association of Securities Dealers

New York Stock Exchange

Options Clearing Corporation

Pacific Coast Stock Exchange

Philadelphia Stock Exchange

40-940 O - 79 - 40

590

**a^.

lU^tj^^ SECURITIES AND EXCHANGE COMMISSION

^ijj^' Washington. D.C. 20549

October 11, 1978

ScmcUI Study
or Ilia

OPtloni Mirketl

Gerald F. Foley

Director, Membership Department

National Association of Securities

Dealers, Inc.
1735 K Street, N. W.
Washington, D. C. 20006

Dear Mr. Foley:

As you will recall, on September 22, 1978, a meeting of
representatives of various self-regulatory organizations
("SRO's") was held at the offices of the Chicago Board Options
Exchange. Also in attendance were representatives of the Commission's
Options Study, Division of Enforcement and Office of Consumer
Affairs. The purpose of the meeting was to discuss (1) how
the SRO's may obtain access to those data bases which appear
to be necessary in monitoring the activities of retail firms,
and (2) the feasibility of Implementing a centralized file
on registered representatives that would facilitate effective
enforcement of applicaole laws and rules. As to this second
objective, the KASD offered to establish a computer-based
system for collecting and dissemating such information.

During the meeting, the SRO participants agreed to submit to
you a summary of the information which they wuuld be willing to
submit for inclusion in the central file, and their anticipated
retrieval requirements. The participants requested that the
Commission's staff make a similar submission. In addition,
the participants requested that the staff describe the categories
of information in the Commission's files which might be helpful
to SROs in their compliance programs and the accessibility
of such data. This letter is in response to those requests.

As you know, significant documentary information in the
Commission's possession is currently available to the public
and, thus, would be readily available for use by the SROs
in their compliance programs. If desired r this data could'-
also bo utilized in the anticipated registered- representative
central file. In this regard, attached is a copy of 17 CFR
200.00a, Appendix A, which lists the categories of information
available to the public at this time. Although some o£ the

591

Gerald Foley
Page 2

documents listed in this Appendix may not be relevant to your

proposed undertaking, others (indicated by check marks) appear

to contain the type of information the SROs are seeking. As reflected

in the Appendix, the Commission can make available the results

of formal administrative proceedings civil injunctive , or criminal

proceedings and copies of any pleadings, briefs or other documents

filed in any civil action to which the Commission is a party.

Hie Commission's Office of Consumer Affairs also receives
investor complaints, many of which involve registered broker-
dealers. These complaints, or a summary of them, could be trans-
mitted to the central file on a periodic basis.

The Commission also maintains confidential investigatory
files. These files are non-public, unless the Commission authorizes
their release. There is a procedure, however, by which SROs may
request and, in most instances obtain, access to these files.
In summary, a letter requesting access must be sent to the Director
of the Commission's Division of Enforcement, who, in turn, refers
the matter to the Commission. In most instances, the Division will
recommend that the request be granted, except when access might
impede or otherwise adversely affect the pending investigation or
otherwise would be inappropriate.

We understand that this procedure has worked efficiently in
the past, and the SROs should have no hesitation in contacting
the Division of Enforcement oefore initiating an examination.
If the SROs believe that the time normally required to respond to
such requests (about three weeks) is too lengthy, the Options Study
would be willing to recommend that the Commission establish a
special procedure to consider such requests on a.i expedited basis.

In any event, upon the conclusion of an investigation, the
contents of the investigatory file normally will be made available
for review and analysis by SROs under the Freedom of Information
Act. While the Act and the Commission's regulations thereunder
designate certain procedures which must be followed, the processing
time is usually no more than ten days. To the extent that
these procedures result in unreasonable delays in responding
to requests for access, the Options Study would be willing
to urge the adoption of a more streamlined procedure.

592

Gerald Foley
Page 3

The Options Study would also bo willing to recommend that
a procedu. be- eL'-wli-hed whereby the Commission's Division of
Enforcement would discuss with representatives of SRQs examination
and investigatory techniques utilized by the Division to identify
potential violations of the federal securities laws by retail
firms, with particular emphasis on recently concluded significant
administrative and injunctive actions.

With respect to the anticipated central file on registered
representatives, we believe that the file could be established
quickly and economically through a slight modification in
the current NASD files on registered representatives by providing
for the inclusion of summary information respecting customer
complaints. This data could be furnished periodically, perhaps
monthly, by the SRO's and their member firms. Similarly, once
a month the NASD could provide the other SRO's with a summary,
by firm, of the information received.

While a simplified program such as that summarized above would
facilitate the prompt estaolishment of a centralized file on registered
representatives, with modest enhancements the potential uses of the
file could be expanded significantly. In this regard, it wouid seem
reasonable to contemplate that the centralized file might contain
ultimately the following data; many of which are already present
in the NASD's files:

- Name of salesman

- Current home address

- Type of qualification examinations passed

- Current employer, type of employment (e.g. salesman, partner or
member) type of business (e.g. options, municipals, or general
securities), and branch office

- Employment history as reflected in current form U-4 including the
name of firms where previously employed, dates of
employment, reasons for chance of employment (voluntary
resignation, termination for cause, etc.)

- Summaries of disciplinary action (formal and informal) taken by
SROs and SEC, etc.

- Summaries of customer complaints and their disposition

It would also be desirable if the system would reflect any pend-
ing investigations by SROs of specific individuals.

593

Gerald Foley
Page 4

Data for the centralized file would be obtained from the SROs,
the Commission and member firms, which could be required to report
•all coc^'-ints ... Li*, file operator. In this regard, enclosed is
a copy of the complaint codes utilized by the Commission's Office
of Consumer Affairs. Perhaps a similar system could be developed
for use by the SROs.

From this data base, the system could have the following capabilities.

Significant activity alarm-. The system could be programmed to
automatically "flag" signincant activity on an individual and firm
basis. Standards such as the following might be considered:

- Identification of each salesman who receives two or more
complaints during a 30-day period or three or more complaints
in a six -month period;

- Identification of each branch office of a firm that receives
three or more complaints in a 30-day period or four or more
complaints in a six-month period;

- Identification of each firm that receives five or more com- .
plaints in a 30-day period or eight or more complaints in

a six-month period;

- Identification of salesmen who change employment and who
are under investigation by an SRO or who have been

the subject of formal or informal disciplinary action
by a firm or an SRO; and

- Identification of salesmen who are terminated for cause or
resign voluntarily during the pendency of an unresolved
customer complaint or SRO inquiry.

Data available u-xpn recrjest. In addition to identifying areas
of significant activity ir.e system could provide certain informa-
tion on an "as-needed" basis, such as in connection with SRO investi-
gations into customer compxamts and terminations for cause. In summary,
it would seem reasonable that the system could be programmed to
provide within a reasonable time period, perhaps 4b hours, a print-out
of the data recorded for an individual salesman. In addition, it
might be helpful if the program could provide a summary of customer
complaints by firm and by branch office, in order that SROs may
consider whether particular intelligence data is indicative of a
more widespread problem.

594

Gerald Foley
Page 5

Periodic reports. Certain information could be disseminated
to the SROs on a periodic basis. Such information might include the
following:

- By firm, number of customer comDlaints received;

- By firm, the location of those branch offices whose
salesmen have received the largest number of complaints;

- By firm, the number of complaints by product and by
nature of complaints; and

- By firm, the name of those salesmen who have received
the most complaints over the past two years and within
the preceding 30 day period.

Pre-examination reports. In anticipation of a sales practice
examination, the examining SrtO could request a special analysis
of the data on file in the central file. Among the analyses that
might be requested for major retail firms are the following:

- A list of salesmen who have joined a firm in the past
year who have not been employed previously in

the securities industry;

- A list of salesmen wno have had two or more complaints
in the preceding twelve months;

- A list of salesmen who have been employed at four or
more firms in the past six years;

- A list of the branch offices which have received the most
customer complaints in the past two years; and

- An analysis of the customer complaints against salesmen
of the firm during the past twelve months, including an
indication of those categories of complaints that have
varied significantly from the prior examination.

The foregoing are preliminary general observations respecting
the potential organization and operation of the centralized file on
registered representatives and the compliance-related data possessed
by the Commission and its availability to SRO's. It may be, of
course, that these proposed guidelines and retrieval capabilities
should be modified to take into consideration the size of different
retail firms or other factors. .This should be a subject for discussion
by the subcommittee at its next meeting.

595

Gerald Foley
Page 6

The views and suggestions expressed in this letter are those
of the Options Study. While this letter has been discussed with repre-
sentatives of other internal offices and divisions, we have not received
their definitive comments. In the event that material modifications
are recommended, we will advise the subcommittee.

If you would like to discuss any of the views set forth in
this letter, feel free to contact me directly at (202) 755-1283.

Sincerely,

Van P. Carter
Assistant Director

596

which is set forth In \hm Corn ml Satan's
current Gchedula of Xees.

(Hi) Tranacrtnta Of public K&xrtnct.
Copies of tas transcript* of recent puhilo
hcarUiRn may be obtained from tm» re*
porter subject to the f f*n rfltrvbll*he<l an-
nually by contract bctwrra Uio Comail*-
don and the reporter. Copies of that con-
tract, which con ulna Ublrs of charges,
may be lur.pecuxl In the puollc rerercaca
room. 1100 L CLreet NW., Wiwnlrurton.
D.C. and In etch regional and branca
Qdce. Copies oX other public transcript*
may bo obtained, In the manner of otner
Commission records, subject to the
charges referred to in paragraph
(o> (7) (1) or this section.

(f) Release* and publication*. (1) Tfcs
Commission's decisions, reports, orders,
rules and regulations are published ini-
tially in the form of releases end dis-
tributed to the press. Certain decisions.
tad reports thereafter are printed In
bound volumes entitled "Securities and
Exchange Com mi ".-ion Decisions and Re-
port*": these volumes may be purcnased
from the Superintendent of Documents.
UJB. Government Printing CrJlcc, Wash-
ington, D.C. 20102.

(2) The Commission publishes daily
the SEC Keics Dicest, which summarizes
the releases published by the Commis-
sion each day, contains Commission an-
nouncements, and lists certain clir^s
with the Commlsrion. The Commission
publishes weekly the SEC Locket, which
print* in fuli the text of every Commis-
sion release. Subscriptions to tho SEC
News Digest aid the SEC Docket m?.y be
purchased from the Suoenntencsnt of
Documents. Government Printing Oilce,
Washington, D.C. 20402.

<3) The Commission publishes mi an-
nual report to ths Cocrress which sets
forth the result of the Commission's op-
erations during the past fiscal year under
tho various staaites committed to its
charge. Copies may be obtained from the
Superintendent of Documents. Govern-
ment Printing Cince. Washington, D.C.
20402.

(4) The Commission also makes other
information In the neids ot securiticj and
finance, inducing economic studies,
available to the public tnrourh the issu-
ance of releases on apccinc subject
matters.

(5) A classification of the releases
available from tha Commission Appears
below as Appendix B to this section (17
CFR 200.80b). Other publications avail-
able from the Commission are set forth

in Appendix C to this neetSna #«• -^
200.COC). Copies of statute rvJ^Z
re^ulaUons. and ralwrllari*oua *-nI7
Won* set forth m Appendix D to trs^T
t!on (17 cm sno.SMl rrny b* r.7=^-^
from the 8upertnr/mclertt of r>r^LJ
UJ3. Government Printing OSce wL?
LaKton. D.C. 20402. ' ^*

(ft uac. S22b). [4o m rros. i^ a ,„

a* amended et 40 PR 57448 i>y »0" 'a-t
fa ',-i'Qi. Dec. 9. 1870; 43 TO U%3! uJ\,
1377] "*• *

§ 200.80m Appendix A— Dnemn^,
materials available to tbe poLlie.
Sscosznss Act ot 1933

fvrnmx to

Registration statement pro-
viding financial and other
information osacenuag
secuxitloa offered for pub-
lic sale, filed under Regu-
lation C (17 cm 230.400
« seq.) _

Prospectuses (sailing circu-
lars) in connection wita
registration statement

Periodic reports (annual,
quarterly, and current) to
ieep reasonably current
the information la regis-
tration statement .

Bequests for extension of
uos to Sis information,
document, or report...—

Reporta of sales or reentered
securities and use of pro-
ceeds thereunder by Srsi
Ume registrants .... .

Eeport by issuers of cecu-
7iv.es quoted on NASDAQ
Inter-Dealer Quotation
System ,—«,,..,—

Preliminary data 1 rrcspec-
tua. circular letters, etc)
to oU offering 1 Regulation
3) (17 CFR 330.300 et
eeq.)

Cffer.ng abeeta for oU cr ma
rights and royalties under
Regulation B for exemrv-
tlon from registration Dro-
risiona (17 CPE 230.300 et
seq.)

iffouncatJona of exemption
from registration fiied
under Regulation A. 2.
and P (17 CFR 230331.
330.601, 230.031 et esq.)

(*)

(•)

W(»).»:n

(l)

3(b)

'Section 15(d)— Securities «Sfttt*ajS let
Of 19S4.

•Section Ufb)— Securities Exchange ad
oX 1934.

184

597

Chapter 11 — Securities and Exchange Commission I tOO.GOo

Pwruantto

Pmentto

DctotipttoH

Off«tng circular* and writ-
ua advert; *-m en te or
other coinmuiLicnUorji un-
der Reculatlone A. HL and
F (17 Cm 2J0-251. 230.601.
230.651 etwo.) -.

Beport of soJr* and um of
proceeds (IteeulaUons A
and E (17 cm 230331.
230.601 et xq.)

Consent by non-re*ident to
ssrrlce of procer* (Regula-
tion A) (17 CT3 220331
et esq.)

Application for relief from
disability under Regnia-
Uous A and P (17 C7S
230.631 eteeq.)

Node* of proposed n, sale of
restricted securities and ra-
tal* of securities by con-
trol persona (17 C7R 230
144)

Woace of proposed aa> by
aon-controlim* person of
restricted 6ecuriCe* of ia>
fuers which do not satisfy
all of the conditions of
Bale 144 (17 CTP. 230.237) .

Kotlce of saie of w»curttiea by
eloaely held issuers ( Is-
suers with 100 or :« bene-
ficial owners) other than
inrestznent companies,
registered or required to
be registered under the In-
vestment Comrvir Act of
1940 (17 CFR 2303*0)

a(b)

«(*)

«0»

Kb)

.. 4(1). 4(4)

3(b)

SacQurxrs Excuxncx Act or 1934

Registration statement <a**
cuntles listed on a ration-
al securities exeats re) 13(h)

Registration statement t se-
curities traded orer-the-
eounter) ... 13(g)

tomptlon from section 12
(g). 13. 14. 15. or l? 13(a)

Information by a foreirn is-
suer temporarily exempt
from sectJon 12'c) ._ 13(g)(3)

Certification or cxcl.onra ap-
prortng securtr.rs for list-
ing and registration 13(d)

ftriodle reports < annual,
quarterly and current) to
fceep current the iaforma-
tloa in tbe abore registra-
tion statements _._ 13(a)

Bequest for extension of
Urn* to flla inf ormaaon.
document, or re?ort._ 13(b)

Gareepondence botween the
Commission and rens-
tranta that are delinquent
in filing certain required
reports 1J(»), 15(d)

Description j

ZLeport by Usuere of eecurl-
ties quoted on NASDAQ
Inter - Dealer Quotation
System _ 18(d). 13(a)

Certificate of termination of
RppiBU-auon for a cLuaa of
security (•)

Notices of suspension of
trading 13(d)

Application to withdraw or
strlxe a security from list-
Lac and registration on a
national eecuntlos ax-
change --r-,,,,.. ......... 13(d)

Notification by an exebaaea
of the admission to trading
of a substituted or addi-
tional class of security.... 13(a)

DeflnJtlre proxy eoiiciting
materials filed under Reg-
ulation 14A (17 C7a 340.-
14e-i et seq.) 14(a)

Distribution of Information
to security holders from
whom proxies are not
solicited filed under Hern-
iation C (17 C7R 230.400
etaeq.) 14(o)

Acquisitions, tender ofiers
and solicitations. (1. CTB
240.14d-l et seq.) 13(d). 14(d)

Initial statement of benefi-
cial ownership of equity
securities by officers, di-
rectors and principal
stockholders of Issuers
having listed equity rocu-
rltlcj; and changes in such
ownership ..^.. 13(a)

Application for permission
to extend unlisted tracing
prlrtleres, notification of
changes, and notification
of termination or suspen-
sion 13(f)

Application for registration
as a broker and dealer. /

and amendments or cup- ^

piemen t§ to such aopuca-
tlon .' 13(b)

Eoports of financial condi- j

tlon of reentered broxers
and dealers , 1?

Application for registration

ae a transfer agent and V
amendmenu to such ap-
plication l7A(o)

Application for rerlscration /

aa a municipal securities *

dealer . . 133(a)

Application for reglstrauon
or exemption as a aecurl- -/

Uas InformaUon proces- v

HA(b)

•Qectlon 13(g)— Securities Exchange Act of
1634.

XS5

598

tttO.QOo

Tlrie 17— Commodity and SocvrlHct Exchanges

Pvrmant to

Description
Application for registration
or exemption ee a cleanup
agency - —

Irrevocable appointment of
agent for service of process.
pleadings and ouasr
papers ..................

Notice by non-resident
broker or dealer specifying
address of place in United
States where copies of
books and records are lo-
cated and undertaking to
furnish to Commission.
upon demand. copwe of
books and records he Is re-
quired to maintain— ....
Subordination agreements-
Initial assessment and Infor-
mation form for registered
brokers and dealers not
members of a registered
national securities assort*

17A(b)

»(a)

17
1ft

— 16(b)(8)

Annual assessment and In-
. formation form for rerls-
v tered brokers and dealers
not members of a regis-
tered national securities

association — 13(b) (8)

Reports of marr*t makers
and other registered brofc-
\J er-deslers in securities
traded on national securi-
ties exchanges ... 17(a)

Reports by registered brokers

J and dealers who are OTO

Market In Makers In any

OTO Margin Securities...

Proposed rule changes by all

self -regulatory organlce-

17(a)
lfl(b)

Notice as to stated policies,
practices and interpreta-
tions of self-regulatory
organisations ..——.—

Application by an exchange
for registration or exemp-
tion from registration as a
national securities ex-
change . , i I,

Annual amendments and
supplemental material
filed to keep reasonably
current the Information
contained la application
for registration or exsmp-

Rsoord disposal plan of na-
tional securities ex-
changes .. .— ..—

Application for anting
rltles on an exempted

* change .—.—.—«

18(b)

17
23(b)

Description

Periodic reports to keep rea-
sonably current the infor-
mation contained '.a apoti-
catlon for llstinc securities
on exempted exchange—

Certin cation of exempted ex-
change approving securt-
ties for listing ...

Application for rev-istretlon
as s national securities as-
sociation or a^Hlatcd secu-
rities «-ft»»titi/>n

Annual supplement consoli-
dated to keep reasonably
current the information la
the above application..—

Report of changes in mem-
bership status of any of its
members required of na-
tional securities exchangee
sad registered national se-
curities associations..—.

Application by a naucnal se-
curities association or a
broker or dealer for admis-
sion or continuance of a
broker or dealer r-t member
of a national securities as-
sociation, notwithstanding
a dlsquRllfl cation under
section 16A(b)(4) ..-.

Application for review of dis-
ciplinary action or denial
of membership by rsz'j-
securlties

Purrees? «-

12(d)

ISA

15A

17, :

i8A(b)(4)

l5A(g)

Reports on RtabUzin? actsn
ties port a in mr to a fixed
pries oTerlng of securities
registered or tc be rezis-
tered under the Securities '. .

Act of 1633, or chared or .,•

to be offered pursuant to •

sa exemption under Pecu-
lation A (17 Cm :C0J251
et seq.), or being or to be
Otherwise offered if srere-
gate offering pries axceeds
•ftOO.000 17

Plans by exchanges author-
ising payment of special
commission in oonnectlaa
with a distribution of secu-
rities oa exchanr*« — . io

Suspensions of trading of se-
curities otherwise than oa
a national securities ex-
change 19(c)(9)

Annual and supplemental re-
ports of the Municipal
Securities Rulemaking
Board 17 *

186

599

fl UohNm

Exchange Commission 6 600.30a

«jo Uthjtt ZTcxlotsvo Ooscrasrr Act
or 193A

Pursuant to

D4teription

o/ registration
t-ad rnrt*tx*uoo ftatemsnt

m -ihite utility noicinf
e«n^— .c« pro?: " v-

ai and oLz.fr information
(□octraing tne Issue and .

»» oT tecuntlns...

jacsl report* by registered
loMttg companies to seep
•msooaoly current izu" cr-
eation la the registration

6<»);8(b)

3(d)

i^nf!*1*" Tor an order of
gf Commission declaring
rsptstrant has ceased to be
l holding compear ...... 6(d)

jbtesent by a person em*
ployed or retained by a reg-
scered holding company or
subsidiary thereof, or sub-
jest matter In respect oX
vnlcn retained or em-
ployed; and annual state*

sent thereafter— ..

implication for exemption
from provisions of the Act
and applications fu; de-
claratory orders regarding
status of company under
Act by holding companies.
lubsldiartea, and other

15(1)

3(a) (3). 2(a)

(4). 3(a) (7)
(B). 2(a)
(8)(B). 3
(*>). (b)
Twelve-month statement by
bank claiming exemption

under ins Act. S (a) . (d)

Application fcr approval or
mutual semes company or
declaration with respect to
organization and conduct
of business or subsidiary
serrlce company.......... 13(b)

Statement executed by finan-
cial institution authorizing
representative to servo as
officer or director or hold-
ing company or subsidiary.
filed by represcntaure— .. 17(c)
Initial statement of benefi-
cial ownership of securities
filed by officers and direc-
tors of registered public
utility holding companies.
and change* in such own-

•whip 17(a)

annual reports by mutual
and subsidiary

J*sst)f fpftots notion

Application by interested
persons for approvsi of re-
organization plans re-
quired in court proceed-
ings for reorganization of
registered holding cum-

- panies and suUsiaiarm... 11(f)

Application by or on behalf
of persona requesting ap-
proval of payment of fees,
sxpenses or remuneration
for serrtces rendered in
connection with a proceed-
ing In reorganization in a
XJB. Court involving regis-
tered holding companies or
subsidiaries .„,..—....... 11(f)

Notices of intention regard-
ing proposed sals of secu-
rities and other assets not
requiring filing or applica-
tion or declaration...... 11. 12(d).

13(f)

Statements In Justification
of fees and expenses pro-
posed to bs paid... 8(b). 7. 9. 10.

12(d)

Reports to stockholders by
registered holding com-
pany or subsidiary '.hereof
and annual reports sub-
mitted by retristercd hold-
ing company or subsidiary
thereof to a State commis-
sion covering opera Cans
not reported to Federal
Power Commission....—. 14. IS

Textst iKnrKTC-as Act or 1039

Statement of eligibility and
qualification of corpora-
tions or individuals as
trustees under qualified
Indenture under which
debt security h&s been or
la to be Issued SC5. 307

Application lor qualification
of indenture under -chica
security (bonds, deben-
tures, notes and similar
debt securities) has been
or Is to bo issued . 307

Application for exemption
from provisions of the Act
In certain cases — 304(c). (d)

Application re conflict or in-
terest or trustees... 310(b)(1)

Reports by Indenture trustee
to Indenture security
holders with respect to
eligibility and qualifica-
tion under section 310. S13

Application relative to af-
filiations between trustees

and underwriters. llOfbWSl.

310(b)(0)

187

600

ttoojoo

TMa 17— Commodity and SocoHMm Exchange*

DnunaxT Aovxsxss Act or 1940

Application for registration
mi Investment adviser or
to mi find or supplement
ruch mi appll-atioa..-.— 303(c), 304

Application for exemption
sud other relief.......— 306A

T»»<M-»-abls appotntment of
agant for service of proc-

ess. pleadings and otnsr

papers 311 (a)

Notice by non-resident in-
vestment adviser specify-
I ing address of place la
United States where cop*
lee of book* and recorda
are located. or— ...— _^- 304

Undertaking by non-resident
Investment ad riser to fur-
nish to Commission, upon
demand, copies of any
boots or records be is re-
quired to maintain.... , ■ 204

Xirramisrr. Coitrairr Act or 1940

Notification of registration of
investment company, and
registration eu^mfo: cot-
•ring an offering of secu-
Atiee of Investment com-
pany evidencing an inter-
est In a portfolio of securi-
ties in which tie invest-
ment company invests 8(a). 3(b)

Periodic reports (annual and
quarterly) to beep reason-
ably current tbe informa-
tion in above registration
statement

Periodic or interim icpuita
to security holders of reg-
istered investment corn-
panics .........

application for order of tbe
Commission determining
registrant has ceased to be
an Investment oompany...

Fidelity bond, resolution of
board of directors, notice
Of cancellation or termina-
tion of bond for oncers
and employees of lnvcet-
ment companies -who hare
access to its securities or
funds ....... —.^

Waiver of Indemnification of
officers and directors of in-
vestment companies ...

la port of Independent audi-
tors examining records of
investment companies..^.

application by other than
registrant for ■ order of
Commission declaring cor-
porate name of registrant
is misleading or deceptive.

80(a).
80(b)(1)

20(b)(2)

8(f)

17(g)

17(b). 17(1)
17(f)

88(d)

Request by company for cer-
tificate to be issued to Sec-
retary of Treasury

Proxy soliciting matertnl .

initial statement of benefi-
cial ownership of seourlUae
by officers, directors and
other ppedfied Landers of
registered doeed-end in-
vestment companies, and
changes In such owner-
ship

Application for exemption
from provisions of the Act
and other relief

20(e>«

20(f)

Statement of transactions—
exemption Irom provisions
of section 10(f)

Application for an Inellrtble
person to serve as oCicsr.
director, etc. of a registered
investment company.....

Request for advisory report
of tbe Commission relating
to tbe reorgrmzation of
registered investment com-
pany

Report of repurchase of its
own securities by a ciosed-
end company ....

Sales literature rerardis? ee-
eurities of certain invest-
ment companies ..

Statement of the Federal
Savings and Loan Corpora-
tion relating to the exemp-
tion of certain issuers....

Report submitted pursuant
to an order of the Commis-

2(s)(0).*M
W. « ft).

<0>. <d). T
W. 10 {»,

<n. a ut.

(C). 13 (5)

<l).<d)(i>.
14(a). il
(a). l£(i).

« (S), ,bu

«i>. ie).a

0). 23(fl),
28 (b) (4),
(C)(8). 'i
(<1). 23(i>
(2)(C). 3
(C). 25(d),

and Chen.

. io(f) ;•

9(b)

, J
25(b)

22(c) "

24(b) *

8(A)(4)

Documents and records re-
sulting from derivative or
representative law suits.. 33

•8ectlon 851(e)(1) of the Internal Have-
nue Code of 1054 is Applicable.

•Regulstion 14 under the securities Ex-
change Act of li3s is applicable (17 CM
340.1 4a- 1 etseq.).

188

601

Chapter U — SocwriiUs and Exchange- Committlon f t00.80e

Request* or petition* that & change in tb*
^pmina'i r-ajei. regulation* or lorm* be
efH«- comment* oa proposed rule*. retfUl*-
aaai or forms; Lauaaee. ua^ndaeat or ro-
pa] or rules. reguJaiion* or forms p.-omul-
pud under in* Tortou* Act* admiaiatered
tj toe CommivMon.

Jleou'*':*, 'or ao-action and interpretative
HSffS uu ;cspon.^es i,

Transcripts of proceeding* in public bear-
ings including testimony, exniblt* received
D evidence, intermedial* dec^ion*. oral argu-
oeota, motion*, brief*, exception*.
t Commission nndm.TJ. opinions, order*, rul-
▼m*» and notice* Issued for public release.

Pinal opinions of oe Coarruaaion. lnciud-
er concurring and dissenting, opinion*, a*
vta a* orders made by the Commission in th*
dedication of eases.

A record of the final roxm of each member
of the Commission in every Commission pro-
owdiars concluded after Jul* 1. 1557.

Seannrs and comments on propo?ed rules
or jtstement* of policy, etc.. except where
tie writer requests that his comments not
be =ade public.

Periodic reports filed by the International
?v»* for P-ecoastructiea and Development
under Regulation 3VT — Rules 1 to 4. section
13(a) of the Brerten Woods Agreement Act
(17 CTR Part 28o).

Periodic reports filed by the Iater-Amer-
tan Development Baax. pursuant to ZUru-
laaon IA (17 CF?. Part ZM) adopted pur-
R&nt to section 11(a) of tas later- American
Bank Act.

Periodic report* filed by th* Asian De-
velopment Baaia pursuant to Beculauoa Al>
(17 C7P. Part 2Z") adopted pursuant to s«c-
tton 11(a) of the Asian Oe7elopmen: Baax
act.

Copies of paper* filed la court, and papers
tzd document* receired from courts, ore
primarily for tae uss cf *-.K.e Commission at-
torneys and other members of tae staa". These
may not always be ccmp.et* and accurate
and may ccaiaia coanunlic etaa* actaticaa.
However. In appropriate situations, with tae
»pproT*i of the O— co cl '-he G-saerai Couaaei.
eamlastion of suca material may be made
or copies obtained a* a matter of courtesy.

Statement* of policy and Interpretation*
Ttlcb hare been adopted by tae Commiasioa
and are not pubuaned in tae PsEsai. P-xo-

AdmlnlstratlTe staff manuals and instruc-
tions to tae staff that affect a member of tae
pa bile.

Reports by tne Com m mi an to the Con-
pts* a* a wnoi*.

Notices of Commission meetings announced
to the public a* dcacrtoed in I IJJ.tOJ; an-
aouncemenu of Commission action to dose)
a meeting, or any portion thereof, a* de-
scribed in I 200.404(b) and I 200.405(c): and
certification* by tae Creaeral Counsel, purru-
*at to | 300.464. taat a Commission meeting.

or any portion thereof, may be closed to the
public

(6 U.S.C. 652b.) (41 FT* 44fl©«\ Oct. 13. 1978.
ae ameoued at 43 PU, 14693. laAr. id, 1977)

§ 20O.C0L Appendix 0 — SEC release*.

(a) Companies and person* woo are
resutared wua the Commiasion under the
ranou* Acta wul continue vo receive copioa
of ladlrtcuai r«u«v»e* pertaining to rule pre
pnra,)* e>nd rule caaarca uaaar the Act* for
which they are registered.

(b) Otner free reading list distribution
of roiease* ha* been discontinued by the
Com rrr Mien because of ruua* casta aad *tac7
Umitauaaa. However, tae texts cl ail release*
uader tae various Acta, the corporate
reormnt ration releases, aad tae lit: ration
release* ax* cont-aiasd in tae dix: Secret,
which may be purcaascd taroucn -as buper*
laundsnt of Document* a* c^scribea in
I 200^0o of this Part. 7"ao Statu ileal aerie*
raleaae* ar* mnuirrd la the j:-:u:icoi UuL~
let in. which also can Oe ootaiasd oy pure fan—
tnrouga tae Supenatondent oi Documant*.
[40 PR. 1009. Jan. «5. 1673 )

§ ZOO.COe Apoendiz C — Statute*, rniee
and miaccuaneou* poiiiicauons avnu-
abie frooa the Go«emmeia i'rinung
Office.

(a) The current rule* of tar Commlastoa
are not published by the Commission m
pamphlet form, ail -iZO puaile n^.ea and
reguiatioas, laciudiag its Ziulos. of Practioe.
are contaiaed la TlUe 17 of the Cede of Fed-
eral Eeiruitiicos. which also is arsilabie for
purchase from tas Supenateadsat of Docu-
manta. Govomarat Prtaua; Ctioe. Wfah-
la^toa. DjC. 2MC2. .Sew rulos aad rule*
charge*, and otasr Commissica releases, ex-
cept stAtisacal reieesas. a-so are pusiiaaed la
ths Pzcmua Hacjfiza as taey are acopuxi.

(b) Ccpias of the folio-cmr stsRites aad
miscellaneous publications may oe purcaased
from the Superta:eadoat ui Documoats, Gov-
ernment Priatiag Ofitce. 77s/'ii"rtoa. D.C.
204C2. Picase aadress to him carectly all La-
Q'irua. orders aad paymeats concerzung tae
followiag publications:

1. Act pcnpAlets.

Securities Act cf 1933. as amended.

Securities Sxahange Act of 1934. a*
amended.

Public Utility Holding Company Act of
1935. a* amended.

Trust Indenture Act of 1939. a* amended.

Investment Company Act of 1940. a*
amended.

Investment AdTtaer* Act of 1940, a*
amended.

2. Reports end Covnptlorton*.

S£C Annual Report to tae Congrea*.
qro Docisions and FLr porta.
Accounung Sennces releases (compiled,
includes No*. 1 through 112).

189

602

COMPLAINT COOES
Broker-Dealer
Ql. Failure of a broker rr» deliver stock, Co a customer

02 Failure of a broker ~Co "deliver funds to a customer

03 Dividend or interest problems with respect to a broker .

04 Failure to transfer accounts (between brokers)

05 Mishandling of accounts

06 Execution of orders

07 Failure of a broker to send a confirmation to a customer or wrong
information on a confirmation

08 Failure of a broker to sund prospectus to a customer

09 Failure of a broker to obtain a signed margin or customer agreement

10 Margin problems

11 Surcharges, taxes and other fees charged* by a broker

12 High pressure - fraudulent statements

13 Protection offered investors

14 Failure to deliver bonds to a customer

15 Commission rates - other

16 Cannot obtain rate schedule

17 Cannot understand rate schedule

18 Quoted rate different from actual charge

19 Confirmation different from rate schedule

20 No notice of rate change

21 Failure of a broker- to forward proxy material to a customer (the
beneficial owner) or forwarding it late

List of broker-dealer compliant
codes used by che Commission

603

22 Broker clearing operations

23 Problems concerning liquidation of a broker-dealer (SIPC or
otherwise)

When a problem involves a municipal security, place a large "M"
after the name of the security.

Broker-Dealer oociens co-oLaints

25 Improper opcion recommendations (suitability)

26 Excessive option cornnission(s)

27 Option order not executed

28 Margin for options: agreement, computation and excessive

29 Unauthorized option transactions in a customer's account

30 Customer unable to execute transactions in restricted ("out-of
money") options

31 Failure to execute' option-account agreement

32 Failure to receive option prospectus

33 Manipulative floor practices

34 Other - Miscellaneous

604

APPENDIX G

Summary of Statistics Relating to SRO
Routine Sales Practice Examinations

The Options Study requested from the options exchanges certain
information and statistics relating to all routine sales practice
examinations of firms for 1973 - 1977, including the number of inter-
views conducted, accounts reviewed, hours required to conduct an examina-
tion and days reauired to prepare the examination report and conduct any
follow-uo inouiry. 1 / The NYSE was requested to submit similar data per-
taininq to routine examinations which its staff conducted. 2 /

For comparison purooses, the firms which were examined were

divided into four categories based upon their options commission income

for 1977:

Firms with commissions in excess of $1,000,000

between $100,000 and $999,999
between $25,000 and $99,999
of less than $24,499

In general, the Ootions Study's evaluation of this data indicated

that there was little, if any, difference in the scope of each SRO's

examination program regarding firms in these categories that was not

attributable to variations in firm size. 3 / There were differences,

however, in the Quality of examination programs among the SROs.

1 / Aopendix A.

2/ Acpendix B. The NASD was also requested to furnish similar information,
but its submission did not arrive in time to be included in this
analysis.

3 / The Options Study relied almost exclusively upon the statistics and
related information furnished by the SROs, although, when the Options
Study staff noted aberrations from SRO stated policy or significant
variations in data, an inquiry was usually made of the examining SRO.

605

Tne roliowiny sumviary ot tnese exajninations focuses, tnerefore, on firms
wiun options canmission income tor 1977 in excess of $1,000,000.
Vnere were 41 linns in this category, and tney were examinee- 74 times
collectively during 1977.

TrttfEE A

saies Practice Examinations in 1977 of Firms
Witn Options Ca.itiission
Incase in Excess of $1,000,000

S*Q No. of Examinations

Ittot 41 x

CtfUE 10

Ai-lEX 17
PaE 2

PtlLX 4

Total 74

Numoer ot firms: 41

Tne Options Study reviewed 13 of tnese 41 examinations, or
approximately 31*. Tne Options Study reviewed all of the other
33 sales practice examinations conducted oy tne other SPOs.

l. Interviews. There is no requirement that SPOs conduct interviews
at memoer firms. Eacn ot tne skus rely, however, upon interviews with
supervisors ana eiipioyees of tne firm under examination to furnish information
aoout tne firm's organization ana operation. While some SPOs require that
certain inaiviauals oe interviewee, tnis Oecision is frequently left to the
uiscretion ot its examiners.

40-940 O - 79 - 41

606

TAbLE b

Average Number ot Interviews Per Sales Practice
or Capital/bales Practice
Examination Conducted During 1977

Average No.

bKU ot Interviews Hign Low

Nibt, 52 107 11

ArtEX y 20 3

CbOE 5 10 1

PbE 2 3 1

PhbX 1 3 1

The larger numoer ot interviews conducted by the NYSE appears
to ue attnoutaoie, at least in part, to tne fact that NYSE examinations
are usually couioined capital/sales practice examinations, which cover all
assets ot tne t inn's Dusiness, wnereas tne options exchanges focus ex-
clusively on options.

2. Accounts reviewed. Tne numuer of customer accounts reviewed
is also lett co tne discretion of tne SPD examiners. Table C summarizes
current s^O standards, and Taoie D summarizes tne average number of accounts
actually reviewed.

607

lYuii.L C

i-iinii.iuiii Nui.ioer ot Customer Accounts Required Dy SKO
standards To be Analyzed in 1SJ77

Number ot Accounts

for linns witn 10,000 accounts
or less - all accounts

For firms with more than 10,000
accounts - at least 10,000
accounts will oe reviewed, the
exact percentage is establisned
prior to the commencement of the
examination.

Lett to tne discretion of the
examiner

mi-iLX 50 accounts selected at random, and

bO accounts with uncovered writing.

p^l Lett to tne discretion ot the

examiner

PtiiiX Lett to tne discretion of the

examiner

608

TABLE D

Average Number of Accounts Reviewed
per bales Practice Examination in 1977

Average
SHU Number High Low

NYSE * 21,026 **

UtfJE 345 1,044 47

AinEX 235 1,067 60

PhLX 025 2,650 50

k>Sb db 110 66

* Trie NYSE coes not record, in all instances, the total number of accounts
reviewed due to tne exchange's requirement that all accounts be reviewed if
tne firm has less than 10,000 accounts.

xx Tms figure does not include accounts reviewed by NYSE in its capital
examinations.

Tne NYSE's account review standards are significantly higher than
tne options exchanges uecause the NYSE relies extensively upon the firm's
m-nouse computer, when avaiiaole, to conduct the initial account review.
The NYSE examiners initially determine the reliability of the firm's computer
to identity "exceptions" in its recordkeeping system and, if the
system is adequate, utilize the computer to screen the firm's accounts.
Tnus, in many instances, the initial account review is not made manually
oy the NYSE's examiners. Nonetheless, information furnished by the NYSE
indicates that its examiners select an average of 8,636 accounts for more
detaneu analysis, wnicn is usually manual.

609

Not all accounts selected tor review by an SPD are analyzed
tor tiie saiiie purpose, for example, or 300 accounts, an sro
may review bO accounts to determine wnetner requisite customer
inroriiiation is on file, another 75 accounts to determine whether they
nave oeen approved properly to trade options, and an additional 50
accounts tor suitaoility. Tne remaining 125 accounts may be reviewed
ior compliance wicn otner bHJ rules.

j. Lengtn ot bales Practice Examinations. The tijne required to
conduct a routine sales practice examination is directly related to
the numoer ot individuals interviewed and accounts examined. The
N¥bt tneretore spenas more time conducting sales practice examin-
ation tnan any otner bWJ.

TABLE E

average Hours Required Per Sales Practice
Examination in 1977

Average
Time in
brtJ Hours High Low

Nl^tl 502 *

CtsUE 177

HWEX 115

Pbc 80

PHLX 51

x Does not include the hours attributable to the NYSE/capital
examination.

1,129

1,000

378

128

610

Tne time spent in conducting an examination may not reflect
the scope ot an examination because the efficiency of an examination
aepenas upon tne quality as well as quantity of the work performed.
Moreover, it is dilticult to determine whether sufficient time was
taxen to evaluate an account. Some accounts will not contain any
recent transactions, otner accounts will contain a hundred or more.

4. Preparation ot examination reports. At the conclusion of
an examination, each SRO requires its staff to prepare an examination
report, un average, the AMEX requires the least time to prepare its
examination report; the NYSE the longest.

TABLE P

Estimated Average Lapsed Time Required in 1977
To Complete Staff Report on Sales Practice Examination

Average Time
SKU in Days High Low

NYSE

caOE

Al*iEX
PtiLX
PSE

Average

Time

Lays

12U

110

611

APPENDIX H
summary 01 SKU Financial Kesources

Tiie Options btuciy requested tran tne SHDs a summary of their total annual
Oijeratiny expenses and tne numoer ol lull time personnel employed by them for
tne years iy77-lb>7b. Tne following tables summarize tne data turnished by the
;srtJs.

since the sKOs use ditlerent titles to describe functionally similar
oeijarti.ients , tne Options Study asJced that the requested data be apportioned by
tne loiiowiny classiiications:

- Compliance programs — all SKL) activities
relating to tne oversignt ot retail firm
operations, sucn as sales practice examin-
ations, capital examinations, processing and
investigating terminations for cause and
customer complaints.

- rtarxet surveillance programs — all activities
ror monitoring tne trading activities of

SKU memuers.

- Enforcement programs — all activities directed
to evaluating whether or not to recommend or
institute disciplinary action and, if such
action is fatten, to present the SW_) staff's
case to the SftD's adjudicatory body.

612

- /ul otner programs — ail budgetary expenses and
personnel not included in tne above three cate-
gories.

"Expenses" was aerined to include salary, travel and incidental expenses
sucn as court reporter tees. Overhead costs, such as amortized building
expenses, were not included.

tJven thougn tne NASD and N¥5E do not trade options, the figures for those
bWJs were inciudeu because they also monitor the options activities of
tneir members. Tne rigures for the CBOE, tne only SJ3Q which does not trade
equities, are related solely to options activity. Both the NASD and the
FoE re^rted mat, oecause of their organizational structure, they were
unaoie to provide separate figures for tneir enforcment programs. Thus,
expenses wmch uii^nt be expected to be included under "enforcement" were
aosoroed by tne NASD in its "compliance program" and by the PSE in its
"compliance and surveillance programs."

613

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CHAPTER VII
FINANCIAL REGULATION IN THE OPTIONS ,1ARK5TS
INTRODTJCTION

The Options Study examined the financial protections currently
employed in the options markets in order to determine whether sufficient
safeguards and controls exist to protect the options marketplace, and
ultimately customers, from being financially harmed by the failure
of broker-dealers. This examination involved a review of (1) financial
and operational data supplied by The Options Clearing Corporation ("OCC"),
the options exchanges, the National Association of Securities Dealers
("NASD") and the New York Stock Exchange ("NYSE"); (2) OCC clearing
procedures; and (3) information about OCC member clearing firms and
options floor participants. The data covered the period from the end
of 1976 to April 28, 1978 with particular emphasis on the period between
April 13 and 18, 1978 when dramatic upward stock price and volume movements
occurred.

The present regulatory system provides financial protection through
a variety of approaches: (1) the Commission's uniform net capital rule
which requires that broker-dealers maintain a certain minimum amount
of readily liquid assets in excess of their liabilities; (2) the Commission's
customer protection rule which limits a broker-dealer's use of customer
funds and securities in its business; (3) the Commission's and the self-
regulatory organizations' financial reporting and early warning filing
requirements which serve to alert the Commission and the self-regulatory

(615)

616

organizations to broker-dealers with potential operational and
financial problems; (4) the Federal Reserve Board ("FRB" ) initial margin
requirements and the self -regulatory organization margin maintenance
requirements which serve to prevent both broker-dealers and customers
from overextending their financial resources by, among other things,
limiting the amount of credit a broker-dealer may extend to finance
customer securities purchases and holdings; and (5) the Securities
Investor Protection Act ("SIPA") which provides to each public
customer up to $100,000 protection for the customer's funds and
securities held by a broker-dealer if that broker-dealer becomes
insolvent.

Additional safeguards to protect the options market place and
public customers engaging in options transactions are provided by the
OCC's regulation of its members. These regulations establish minimum
net capital requirements for OCC members ( in some respects greater
than those reported by the Commission), regulate OCC clearing procedures,
and set margin maintenance requirements for positions carried at
OCC. The OCC guarantees the performance of all options contracts
accepted by it and its guarantee is backed by a clearing fund maintained
by required deposits from OCC members.

Broker-dealers which confine their business to "maintaining a
market" on the floor of an options exchange, as defined by the options
exchanges, are subject to different Commission net capital requirements
and different FRB margin requirements than those applicable to other

617

broker-dealers and to public customers. The net capital and margin
requirements for market making transactions recognize the special role
of those maintaining a market. in securities.

To conduct its study of the financial integrity of the options
markets, and to test the adequacy of the provisions of the Commission's
net capital rule the Options Study reviewed: (1) broker-dealer financial
data which are collected by the self-regulatory organizations and filed
with the Commission on a quarterly basis; 1/ (2) impact studies and
reports submitted by interested parties; (3) OCC operational and financial
data submitted by the OCC in response to the Options Study's letter
dated May 5, 1978; 2/ (4) OCC clearing member and option floor participant
operational and financial data submitted by the self-regulatory organizations
in response to the Options Study's letters dated June 7 , June 16, and
June 27, 1978; 3/ and (5) two questionnaires ("Form A" and "Form B"),
attached to the June 7, 1978 letter, developed by the Options Study
to obtain certain financial data and operational information regarding
OCC clearing members (Form A) and options floor participants (Form B) . __4/

1/ Form X-17A-5 Part II and Part IIA, appended as Exhibit 1.

_2/ Letter to OCC, dated May 5, 1978, appended as Exhibit 2.

_3/ Letters to AMEX, BSE, CBOE, MSE, NASD, NYSE, PHLX, and PSE, dated
June 7, June 16, June 27, 1978, appended as Exhibit 3.

4/ Form A and Form B, appended as Exhibit 4

618

The Options Study received 150 Form As and over 2,000 Form Bs in
response to its requests and developed 29 computer programs to compile,
edit, and sort the data received. The computer programs, among other
things, sorted and tested the information by exchange affiliation, by
size of market maker equity, by market maker clearing firm and by options
floor participant status ( i.e. , market maker, specialist or registered
options trader) .

Based on these computer analyses and impact studies, the Options
Study concluded that the amount of capital required by existing financial
safeguards is sufficient to protect both the market and public investors
in periods of normal volume and price movements. The Options Study
is concerned, however, that these financial safeguards as they pertain
to broker-dealers maintaining a market on the floor of an options exchange
and OCC member firms clearing their accounts may be inadequate when
there are abnormal volume surges and price fluctuations.

On the other hand, the Options Study concluded that the net capital
requirements appear unduly restrictive in measuring the risks of certain
options strategies engaged in by broker-dealers trading for their own
account both on and off the floor of an options exchange and that these
requirements, in particular, may be discouraging more active participation
in the options market by broker-dealers trading off the floor of an
options exchange and whose participation would possibly contribute
additional liquidity to the markets. These findings are discussed more

619

fully below in the first section of this chapter, "Broker-Dealer
Financial Regulation."

The FRB and the self-regulatory organizations' initial and margin
maintenance requirements are discussed in the second section of this
chapter, "Credit Regulation." The Options Study is recommending
revisions to the margin regulations which would enable broker-dealers
maintaining a market on the floor of an options exchange to better
use stock to hedge against the risks they incur in maintaining
a market. The recommended revision would also restrict the number
of stocks on which any broker-dealer would be eligible to receive
this special margin treatment.

Only certain types of broker-dealer activity will be discussed
in this chapter in order to concentrate on the areas in which the Options
Study believes Commission or self -regulatory action is appropriate.
These include:

— Transactions on the floor of an options exchange
by a market maker in the course of maintaining

a market in options, as defined by the options
exchanges ;

— Transactions by a broker-dealer which is a
member of OCC in connection with financing and
guaranteeing the options transactions of market
makers ("market maker clearing firm");

— Transactions off the floor of an options exchange
by a broker-dealer for its own account ("upstairs
dealers" ) .

The chapter does not discuss the extension of credit to customers,
the use of marketmaker exemptions from the credit regulations, or the

620

ability of the self -regulatory organizations to detect improper
extensions of credit to options marketmakers. These matters are under
continuing study in the Division of Market Regulation.

3R0KER-DEALER FINANCIAL REGULATION

Certain of the broker-dealer financial regulatory controls mentioned
above were established, and others were improved, in response to the
failure of a number of broker-dealers during the period from 1969 to
1972. During that time a number of NYSE members and numerous other
broker-dealer firms, which were not members of an exchange, failed
and were forced to merge or liquidate. Customer exposure exceeded $100
million. 5/ To restore public investor confidence in broker-dealer
firms, and to provide to such investors a measure of protection against
broker-dealer financial failure, the Congress adopted the Securities
Investor Protection Act of 1970 (the "SIPA").

1. THE SECURITIES INVESTOR PROTECTION ACT

The SIPA was designed to protect customers' funds and securities
left with a broker-dealer and is administered by the Securities Investor
Protection Corporation ("SIPC"). As recently amended, the SIPA protects
each securities customer's account with a broker-dealer up to $100,000,
with a limitation of $40,000 for a claim relating to cash. SIPC has

5/ SEC, Study of Unsafe and Unsound Practices of Brokers and Dealers ,
H.R. Doc. No. 231, 92d Cong., 1st. Sess. (1971).

621

established a fond of $150 million which was generated by assessments
on member broker-dealers. In emergency circumstances SIPC can supplement
its fund by borrowing up to $1 billion from the United States Treasury.
SIPA provides for the settlement of customers' claims for securities
by the return of securities to the maximum extent possible rather than
by cash payment.

2. COMMISSION ACTION

a. Commission's Customer Protection Rule

In adopting SIPA the Congress amended the Exchange Act to require
the Commission to prescribe rules regulating broker-dealer "acceptance
of custody and use of customers' securities", and the "carrying and use
of customers' deposits and credit balances." Further, the Commission
was to establish rules requiring "the maintenance of reserves with
respect to customers' deposits or credit balances."

In response to these directives, the Commission, in November 1972,
adopted its customer protection rule. 6/

This rule:

Requires that customers' funds left on deposit

with a broker-dealer and any cash realized
through the permissible use of customers'
securities be used only in designated
areas of the broker-dealer's business related to
servicing its customers. To the extent customer
funds are not used in these areas, they must be
deposited in a restricted, segregated, bank account;

6/ Exchange Act Release No. 9856 (November 10, 1972).

40-940 O - 79 - 42

622

-Restricts a broker-dealer's use of customers' fully
paid and excess margin securities;

•Limits a broker-dealer's ability to use its
customers' funds for dealer activities, such as
underwriting and trading, for its own account;

-Restricts a broker-dealer's expansion of its
business through the use of customer funds.

b. Commission's Uniform Net Capital Rule

Prior to June 1975, a broker-dealer was exempted from the Commis-
sion's net capital rule if it was subject to a national securities
exchange net capital rule that was deemed by the Commission to be more
comprehensive than the Commission's net capital rule. The net capital
requirements of the various national securities exchanges, however,
were not uniform nor interpreted uniformly which resulted in different
capital requirements for firms doing similar businesses.

To further upgrade the financial responsibility of brokers and
dealers, the Commission adopted a uniform net capital rule ("net
capital rule") in June 1975, which established uniform requirements
for all broker-dealers except specialists and other market makers on
a national securities exchange who do not carry customer accounts and
whose exemption from the rule was continued. This net capital rule
continued the basic net capital concept which the Commission and
the national securities exchanges had adopted, but for the first time
established a uniform rule with minimum financial standards.

623

The objective of the Commission's net capital rule is to require
a broker-dealer to maintain a sufficient cushion of assets readily
convertible into cash ("liquid assets") to satisfy all customer claims.
The net capital rule establishes minimum financial requirements
depending on the nature of the business a broker-dealer conducts,
ranging from $2,500, for a firm conducting a business solely in
the sale and redemption of investment company shares, to a maximum
of $100,000 for a firm which makes dealer markets in over-the-counter
securities. Broker-dealers that carry customer accounts are subject
to a minimum $25,000 requirement. 7/

Speaking generally, "net capital" is determined by subtracting
from the broker-dealer's net worth (total assets less total liabilities)
assets that are not readily convertible into cash, such as unsecured
receivables, fixed assets and unmarketable securities. From the asset
balance thus derived there is further deducted a certain percentage
of the value of marketable securities, called "haircuts," ranging
from 1/8 of a percent for commercial paper to 30 percent for common
stock. These haircuts are designed to provide a cushion in the event
of adverse market movement. 8/

The net capital rule also serves to limit a broker-dealer's
volume of business in relation to its net capital. The limitation

JJ 17 CFR 240.15c3-l(a) (1977).
8/ 17 CFR 240.15c3-l(c)(2) (1977).

624

is accompl ished in three ways. First, the rule limits the amount
of unsecured and customer related liabilities a broker-dealer can
assume, by requiring one dollar of net capital for every fifteen dollars
of unsecured and customer related liabilities — an amount defined
as "aggregate indebtedness." Second, the rule provides that the net
capital requirement may be measured by the amount of customer activity.
This is an elective alternative to measuring aggregate indebtedness
and is a derivative of the Commission's customer protection rule.
To determine its required net capital under the alternative, the broker-
dealer must complete a prescribed formula which measures total customer
funds held by the broker-dealer (credit side of the formula) against
the amount of customer activity the broker-dealer has financed (debit
side of the formula). Broker-dealers which elect the alternative are
required to maintain net capital equal to the greater of $100,000 or
4 percent of the debit side of the formula. 9/ The excess of credits
over debits must be segregated in a restricted bank account. Third,
in the case of OCC member clearing firms, the rule limits the aggregate
amount of options positions such firms can finance and guarantee on
behalf of the market maker accounts they carry. 10/ This limitation
is discussed more fully below.

__9/ 17 CFR 240.15c3-l(f).

10/ 17 CFR 240.15c3-l(a)(6), 15c3-l(c) (2) (x)

625

3. THE OPTIONS CLEARING CORPORATION FINANCIAL RULES
The predecessor of OCC, called the Chicago Board Options Exchange
Clearing Corporation, was established by the CBOE to act as agent for
issuing and guaranteeing CBOE listed options contracts and to assign and
process exercised options contracts. OCC, now jointly owned by the five
options exchanges, is the sole authorized issuer and guarantor of listed
options. In addition, OCC is a self -regulatory organization registered
under the Exchange Act. Under authority derived from the Exchange Act,
the OCC has adopted regulations designed to provide financial protection
to its members and public customers with respect to options transactions.
These regulations require a broker-dealer that is an OCC member which
executes, processes, or clears options transactions for itself, customers
or other broker-dealers (1) to maintain a minimum net capital of $100,000;
(2) to pay OCC for options transactions the next business day after the
transactions occur; (3) to maintain deposits at OCC based on a percentage
of the value of short options positions held by the OCC member on behalf
of itself and others for which it clears; and (4) to contribute to a common
fund maintained at OCC to back OCC's performance guarantee of options
contracts in the event one or more of the OCC's members default
on their obligations.

a. OCC Clearing Members
To conduct a listed options business, a broker-dealer must be an
OCC member or have its options business cleared by an OCC member. OCC

62G

membership is typically obtained by a broker-dealer to facilitate its
options business with public customers, to trade options for the broker-
dealer's own account, or to enter into the business of clearing market
maker or other broker-dealer accounts. An OCC member, which clears market
maker accounts, is called a market maker clearing firm. It finances
and guarantees the transactions in the market maker accounts it clears,
and performs the necessary recordkeeping and processing required to clear
the accounts' transactions through OCC. For these services the market
maker clearing firm charges the market makers a fee. On March 31,
1978, OCC had 150 members of which 22 carried the accounts of market makers.

The role of an OCC member as guarantor of the market maker accounts
it carries is a unique feature of the options markets. In establishing
a marketplace for the trading of listed options, the founders of the
CBOE stated that they sought to assure that the market makers on the floor
of the CBOE would not be prevented from entering the market due to highly
restrictive and selective capital requirements. To accomplish this
objective the CBOE looked to the clearing firms which carried these
market makers' positions to provide sufficient capital to protect
the marketplace from a market maker's failure. Market makers that
were not clearing firms or did not do a public business were prohibited
by the CBOE from executing any transaction on its floor unless an
OCC clearing member accepted financial responsibility for all the
market maker's exchange transactions under a letter of guarantee

027

issued by the market maker clearing firm, approved by OCC, and filed
with CBOE. 11/

The MSE and PSE adopted similar requirements. 12/ The AMEX and
PHLX, however, followed their existing equity specialist systems and
adopted minimum financial requirements for each specialist unit. These
rules require that each unit maintain cash or liquid assets of $100,000
at AMEX and $25,000 at the PHLX. 13/ In addition, the AMEX and PHLX
established minimum financial standards for certain members called
"registered options traders," who trade options on the floor of the
exchange for their own account in the same manner as competing market
makers at the CBOE. These requirements are currently $15,000 at AMEX
and $25,000 at PHLX. 14/

Notwithstanding the financial requirements established for floor
participants by the options exchanges, each market maker clearing
firm is financially responsible for the accounts of the specialists,
market makers, or registered options traders (collectively referred to
as "market makers") it clears at OCC and is thereby obligated: (1) to
submit full payment to OCC for all purchasing transactions by the market
maker accounts it clears; (2) to satisfy all OCC margin requirements

11/ CBOE rule 8.5.

12/ MSE art. XLVTI, rule 4; PSE rule TV, Sec. 77.

13/ AMEX rule 171; PHLX rule 1021.

14/ AMEX rule 110 and PHLX rule 1014.

628

for its market makers' accounts; and (3) to satisfy its market makers'
stock or payment delivery requirements on the exercise of call or
pjt options. 15/

The accounts of market makers on the CBOE and PSE are generally
carried by OCC members whose securities business is substantially confined
to performing clearing functions for such accounts ("specialized market
maker clearing firms" ) . The accounts of market makers on the AMEX and
PHLX are carried by OCC members that conduct a more fully- integrated
securities business including a business with public customers ("inte-
grated market maker clearing firms"). The accounts of market makers
on the MSE are carried by both specialized and integrated market
maker clearing firms.

b. OCC Member Capital Requirements

OCC requires that members* net capital, aggregate indebtedness
and alternative net capital be computed in accordance with the Com-
mission's rules. OCC, however, requires greater minimum net capital
than is required under the Commission's net capital rule.

OCC requires each of its new members to have an initial net capital
of $150/000 and from then on to maintain net capital of not less than
$100,000. The member's aggregate indebtedness may not exceed eight

15/ OCC art. VT §§ 4, 14.

629

dollars for each one dollar of net capital at the time it becomes a
member and thereafter may not exceed fifteen dollars for each one dollar
of net capital. Initially, a clearing member electing the alternative
net capital requirement must have net capital of not less than seven
percent of its aggregate debit items and thereafter must have net
capital of not less than four percent of its aggregate debit items. 16/
If on any day an OCC member's net capital falls below 5150,000,
or its aggregate indebtedness increases to twelve dollars for each
one dollar of net capital or, in the case of a member electing the
alternative, its net capital falls below six percent of its aggregate
debit items, the OCC member must notify OCC of these facts by 4:00
p.m. the following day.

All OCC members carrying market maker accounts are subject to the
net capital requirements of the Commission and the OCC, but the market
makers that are not members of the OCC and clear through an OCC member
are exempt from the Commission's net capital requirements as long as
they restrict their securities business to options market making. As
indicated above, an OCC member finances and guarantees the options
transactions of the market maker accounts it carries and, in effect,
provides the net capital required to provide financial protection to
the options market and public customers.

16/ OCC rules 301, 302.

630

c. Commission's Net Capital Requirements
The Commission's net capital rule requires a market maker clearing
firm to reduce its net capital to the extent that the deductions required
under the net capital rule (to recognize the risks of a market maker's
stock and options positions) exceed the equity in that market maker's
account. The equity in the market maker's account is determined by taking
the market value of all long positions in his account, less the market
value of his short positions, adjusted by the amount due to or from
his clearing firm. A positive amount is the equity in the account. A
negative amount would indicate a deficit. Market makers with a deficit
equity position must cease doing a securities business until such time
as the deficit is eliminated. Generally, the deductions required under
the Commission's net capital rule, to recognize the risks with respect
to positions in a market maker's account, are determined separately
for each options class held in the market maker's account by multiplying
the market value of net long positions by 50 percent and net short positions
by 75 percent. Whichever is the greater amount — be it 50 percent of
the long positions or 75 percent of the short positions in the particular
class — is the required deduction in that options class. If the aggregate
of the deductions for all the classes of options held by the market maker
exceeds the equity in the market maker's account, the OCC member which
clears that account is required to reduce its net capital by the amount
of the excess.

631

Any time the market maker clearing firm is required to reduce its
net capital because the equity in a market maker's account is less than
the deductions with respect to the account, the OCC member is prohibited
from extending further credit to that market maker account unless the
carrying firm either (1) reduces its net capital by the amount of the
equity short fall, or (2) calls upon the market maker to add sufficient
equity to the account to eliminate the net capital charge. If a market
maker fails to meet a call for additional equity, the OCC member must
liquidate the market maker's account and give notice of the market maker's
failure to meet the call to the Commission, and to the self -regulatory
organization responsible for examining the financial condition of the
OCC member and the market maker.

Each market maker's account must be computed separately. Market
maker clearing firms are expressly prohibited from offsetting a deficit
in one market maker account with the excess equity in another market maker
account. 17/

The Commission's net capital rule also limits the volume of market
maker business an OCC member can carry in relation to its net capital.
This provision was designed to prevent an OCC member firm from carrying
excessive market maker positions and to provide a cushion of capital in
view of the unique and somewhat risky nature of the business of carrying
market maker accounts. Currently, the net capital rule requires that the

17/ Exchange Act Release No. 12766 (September 2, 1976).

632

aggregate deductions with respect to all the market maker accounts
carried by an OCC member, not exceed ten times the carrying firm's net
capital for a period exceeding five consecutive business days.

d. OCC Settlement Requirements

The premiums owed to and by OCC members as a result of the options
transactions cleared by them are due in cash the business day following
the transactions. These premiums and other amounts owed OCC are referred
to as "margin deposits/' although they bear no relationship to FRB margin
requirements.

OCC clearing members maintain separate clearing accounts at OCC
defined by the origin of the transactions in the accounts. One account
is maintained for options transactions for public and non-market maker
broker-dealer customers ("customer account"). A second is maintained
for options transactions for the OCC member's own account ("proprietary
account" ) . A third account is maintained for options transactions for
the market maker accounts carried by the OCC member ("market maker account")

OCC determines, daily, the settlement requirements for each options
class in each of these separate accounts. Amounts due to and from OCC
are netted within each account to arrive at a daily settlement amount
for each separate account.

The net amount due to and from OCC is determined differently for
the customer accounts than it is for the proprietary and market maker

633

accounts. Long options and short options positions in customers'
accounts are not netted against one another. The premiums on all options
transactions must be paid in full and, in the case of uncovered short
options positions, the short options premium plus an additional 30
percent of that premium is also due to OCC to protect against the risks
of adverse options price movements. All short options positions are
treated as uncovered by OCC until it receives a depository or escrow
receipt for the underlying stock. No margin offset for long options
positions in customer accounts is permitted by OCC since these positions
must be segregated by broker-dealers pursuant to the Commission's
customer protection rule which generally prohibits a broker-dealer
from subjecting customers' fully paid securities to a lien. 18/

When computing the margin deposit for options positions in firm
proprietary and market maker accounts, long options positions can be
used to offset short options positions in the same options class by
pairing the long and short positions on a contract-by-contract basis.
The market value of the paired long and short options positions
are then totaled. If the total market value of the short options
positions exceeds the total market value of the long positions,
130 percent of the excess must be deposited with OCC. In addition,
130 percent of the market value of total short positions which are

18/ OCC Rule 601a.

634

not paired with a long position in the same options class must be
deposited with OCC. The premium received on the sale of short options
positions is left with OCC and can be used to satisfy the deposit
requirement. In addition, if the total market value of the long
options positions exceeds the total market value of the paired short
positions, 70 percent of the excess long positions market value
can be used to meet the "margin deposit" for unpaired short options
positions in the same options class in the particular account and,
to the extent not so used, 35 percent of the excess market value
of any long options position may be used as "margin" for amounts
due OCC for other options classes in only that account. 19/

For purposes of these computations, assignment of an exercise
notice to an options account will result in treating options contracts
that have been assigned as uncovered short positions unless they
are offset by long positions in the same options class, or, if calls
are involved, the calls are covered with the underlying security.

The following chart sets forth an example of the computation of
the margin deposit in a clearing firm's proprietary or market maker
account with both net long and net short positions in different
classes of options.

19/ OCC Rule 601b.

635

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636

OCC members clearing market maker accounts may establish at

OCC either a separate account for each market maker or a combined

account for all market maker accounts it clears. In either case,

the OCC member must obtain from each market maker for which the

member clears an account, an agreement which provides that:

— OCC has a lien on all long positions, securities,
margin and other funds in the market maker's
account as security for the clearing member's
obligations for all transactions effected in the
account, short positions maintained in the account
and exercises assigned to the account;

— OCC has the right to net all short positions
against all long positions in the account; and

— OCC can close out the position in the account
without prior notice to the market maker.

If the market maker positions are carried in a combined account the

agreement must also provide that the positions of one market maker can

be combined in the account with other market maker's positions. 20/

Most OCC member market maker clearing firms maintain combined

market maker accounts at OCC because netting one market maker's

position with another may reduce the clearing firm's OCC "margin

deposit" requirements. The market maker clearing firm's net capital

requirements, however, are the same whether the market makers'

accounts are maintained at OCC on a combined or separate basis.

20/ OCC art. VI, § 3.

637

The daily settlement amounts, or "margin deposits," due to OCC
are either paid utilizing excess cash in the member's margin account
at OCC, or are obtained through the issuance of a draft upon the OCC
member's account at an approved bank on which OCC is authorized
to draw.

Although OCC initially requires cash to satisfy amounts owed to
it, clearing members may subsequently deposit with OCC during the day
approved bank letters of credit, United States government securities
maturing within 10 years, or stock underlying uncovered short options
positions, and they may withdraw any excess "margin deposits". 21/

United States government securities or securities underlying short
options contracts are not deposited directly with OCC for margin purposes,
An approved bank, trust company or securities depository will issue a
depository receipt to the OCC member which directs the bank, trust
company or depository to deliver the receipted securities directly to
OCC upon written request. Another method of depositing securities
is an escrow receipt issued by an approved custodian in either the
name of an OCC clearing member, or its customer, representing that
the custodian will deliver the escrowed securities to OCC or the
clearing member upon assignment. 22/

OCC has the authority to demand additional "margin deposits"
("variation margin calls") from any one or more of its members for

21/ OCC rule 604.
22/ OCC rule 610.

40-940 O - 79 - 43

638

expected but unpredictable occurrences, such as rapid price and
volume changes, when the regular daily "margin deposit" requirements
described above might prove to be insufficient.

Variation margin calls typically will be made when there is
a sudden movement in the Dow Jones Industrial Average ("DJIA") or
if the next business day is a bank holiday in one of the cities
in which OCC maintains a clearing facility. OCC will make a variation
margin call demanding a 10 percent increase in the clearing member's
regularly required margin deposits by 12:00 noon if the QJIA is
then up or down ten points from the previous close or if the clearing
member's bank will be closed on the next business day. If the DJIA is
up or down by 20 points or more, the variation margin call will amount
to a 20 percent increase in the regularly required margin deposit.
From 1975 to May 1978 the OCC made thirty-two variation margin calls.
Twenty- four were due to a ten point QUA move, one was due to a 20 point
DJIA move and seven were due to bank holidays. 23/

In determining whether a variation margin call will be issued
to a particular clearing firm, OCC reviews the member's accounts for:

— Market price fluctuations in an options series
held in a short position in such account;

— Market price fluctuations of any security
underlying a short option that has been
exercised;

23/ OCC submission, Vol. II, Sec. IV J, May 29, 1978.

639

Changes in the size of a clearing member's
options position; or

Changes in the clearing member's financial
condition. 24/

e. OCC Clearing Fund
For the protection of options customers and OCC participants,
OCC requires each new clearing member to contribute to an OCC
maintained common fund (the "clearing fund") an initial base
contribution of $10,000 plus such variable contribution as may be
fixed by the Board of Directors in its discretion at the time such
clearing member's application is approved. Effective October 31,
1978, each OCC member is required to maintain on deposit with OCC in
the clearing fund a base contribution of $10,000 plus a proportionate
share of the variable portion of the clearing fund. The variable
portion is 7 per cent of the average daily value of all clearing
members' option contracts in open short positions during the preceding
calendar quarter. A clearing member's proportionate share of the
variable portion of the fund is a fraction; the numerator of which
is the average daily number of option contracts carried by such clearing
member in open positions during the preceding three calendar months and
the denominator of which is the average daily number of contracts
carried by all clearing members during the period. Ttie contribution
each OCC member is required to maintain in the clearing fund is
currently recomputed at the end of each month.

24/ OCC submission Vol. II, Sec. W J, May 29, 1978,

640

The clearing fund is available to OCC if: (1) a clearing member
fails to fulfill its exercise or assignment obligations; (2) a clearing
member fails to make any required payments to OCC; or (3) OCC suffers
any loss or expense upon the liquidation of a clearing member's open
long or short positions. If a clearing member's contribution to the
clearing fund is insufficient for these purposes, the deficiency is
paid out of the aggregate clearing fund and charged against all other
clearing member contributors in proportion to their contributions. 25/
Clearing fund deposits are not refunded until a clearing member has
ceased to be an OCC member, each of the firm's obligations with OCC
have been fulfilled or closed, and all obligations have been satisfied. 26/

4. STUDY OF THE FINANCIAL INTEGRITY OF THE OPTIONS MARKET
To examine the effectiveness of the complex controls and devices
that the OCC and the Commission have established to provide financial
protection to the options market and public investors, the Options Study
obtained extensive financial data from OCC and the options exchanges. 27/
While the data covered most of the time during which listed options have
been traded, special attention was given to the period of high stock and
options volume and sudden price movements that occurred between April 13

25/ OCC art. VIII, §5.

26/ OCC art. VIII, §7.

27/ Letters to AMEX, BSE, CBOE, MSE, NASD, NYSE, PHLX, and PSE, dated
June 7, 1978, and letter to OCC, dated May 5, 1978.

641

and April 18, 1978 (the "April market surge"). This period was chosen
to determine the effectiveness of OCC margin and clearing fund requirements
and the Commission's net capital rule during a sequence of abnormal price
movements and volume changes. During this period the DJIA increased approxi-
mately 44 points. NYSE volume increased from 31.5 million shares on April
13, to 52 million on April 14, and 63.5 million on April 17.28/ OCC
contract volume increased from about 225,000 contracts on April 13, to
443,000 contracts on April 14, to a high of approximately 619,000 contracts
on April 17. These figures compare with a daily average OCC cleared
contract volume of 192,000 contracts during the year July 1977 to
June 1978.

While the DJIA increased approximately five percent (766 to 810)
between Wednesday, April 12, and Monday, April 17, some of the more
active stocks underlying listed calls increased in price ranging from
five percent to eight percent. Premiums on the related options increased
from 366 percent to 4,300 percent as set forth below: 29/

Stock Up_ Call Up_

Digital Equipment 8.0% April 40 483%

Disney 7.1 April 35 633

Dupont 8.3 April 110 4,300

Eastman Kodak 5.0 April 45 400

IBM 6.3 April 240 1,005

Polaroid 7.9 April 30 366

28/ Wall Street Journal, April 13, 14, 17 and 18, 1978.
29/ Business Week, May 1, 1978 at 26.

642

During the April market surge, two of the OCC's eight largest
members carrying market maker accounts (their size determined by the number
of market maker accounts carried) could not meet the Commission's net
capital requirements. On April 17, 1978, the accounts of 85 market makers
were in a deficit condition and the net equity in the accounts of market
makers in the aggregate declined from $85.5 million as of April 14, 1978
to $74.3 million as of April 17, 1978, a decline of approximately $11.2
million. 30/

Due to sudden price and volume increases, OCC made variation
margin calls on certain of its member firms on April 14, 17, 18, 20 and
25, 1978. The amount of the variation margin calls on these dates, the
number of member firms on which calls were made, and the particular
accounts carried at OCC which were affected by the calls were as
follows:

Variation
Margin Call
Per Cent of

Regular Mar- Total Number
DATE gin Deposits Amount of Firms

(000 omitted)

4/14

10%

$ 32,617

4/17

90,244

4/18

19,233

4/20

13,786

4/25

49,259

Accounts

Market
Maker

Customer

Pro-
prietary

(000 omitted)

$ 2,651 $ 29,642 $ 324

10,439 77,298 2,507

3,543 15,130 560

301 13,299 186

1,383 47,368 508

30/ Table No. 1 appended as Exhibit 5. Under normal conditions,
between 30 and 40 marketmaker accounts may have a deficit.

643

During this period all OCC members satisfied their variation margin
calls. 31/

a. Margin and Clearing Fund Deposits
In order to assess the adequacy of OCC's margin requirements and
clearing fund deposits OCC conducted a computer simulated test in
June 1978, based on the following hypothetical assumptions:

— Each (but only one at a time) of OCC's 50 largest
clearing members - 18 of which cleared market maker
accounts - failed on Friday, April 14, 1978;

— The premium and margin due to OCC by that firm, based
on its April 13 activity, was collected Friday,
April 14. This amount did not include the varia-
tion margin call made on April 14; and

— OCC liquidated the firm's positions on Monday,
April 17, 1978, at the closing prices.

This period was used since, as previously described, it was one

of unexpected and rapid price increases and as of April 17, 1978

option premium value were at their high or near their high for this

period. Based on these assumptions and using OCC margin and clearing

fund deposits available to OCC it was determined that of the 50 firms,

28 could have been liquidated without resorting to their clearing

fund deposits. Of the 22 remaining firms, 15 would have had sufficient

margin and clearing fund deposits to cover the cost of liquidation,

and the remaining seven would not. The deficiencies would have ranged

31/ OCC Submission, Vol. II, Sec. IV J, May 29, 1978.

644

tram $5,5ui) to $931), Out) witn $61 million in aggregate clearing fund
deposits on nana. All seven tinas wnicn would nave had inadequate
resources cleared accounts of marKet maxers.

neiore this test was conducted, OCC had submitted to the Commission
proposals to amend its margin and clearing fund deposit requirements in
order to increase the margin tor short term near-the-money options and
to calculate tne OCC member clearing fund deposit requirements on
options prenium values during the preceding quarter. rib determine how
implementation or tne proposed changes would have altered the original
test results, a second test was conducted using the same assumptions as
in tne tirst test out adjusting tne margin and clearing fund deposit
requirements to retlect the proposed changes. The second test showed
tnat 34 ot tne 51) lirms could have been liquidated without resort to
tneir clearing fund deposits — six more than in the original test,
however, tne number ot members whose margin and clearing fund deposits
would not have covered tne cost of liquidation also increased —
irom seven to eignt — as did tne nypothetical deficiencies which
ranged Iran $54, Out) to $1 million. Due to low premium values during
tne preceaing quarter, nowever, tne total clearing fund deposits
on nand would nave been only $21 million. This amount would have
sutticiently covered any deficit. As in the original test, seven
ot tne tirms which would have had inadequate clearing fund deposits
cleared accounts ot marKet maKers. 32/

32/ Letter Irom ware L. Herman, Vice President and General
Counsel, UCC, dated July 18, 1978.

645

Tne results ot tnese tests indicated tnat OCC's margin and
clearing tund deposit requirements provided OCC with adequate financial
protection in tne aggregate, and since tne OCC proposals to amend
its margin and clearing fund deposits requirements increased margin
requirements tor snort near-tne-money, near expiration options and
measured clearing rund deposit requirements by premium value they
were adopteu. Tnese tests also snowed, nowever, that additional margin
snould oe required trow OCC members tnat clear market maker accounts.
Tne roliowing table demonstrates that, based on the assumptions
made in OCC's tests, the greatest impact on the clearing fund would
nave come from OCC memoers clearing market maker accounts. This is
oecause tne positions and accounts of options market makers are netted
at OCC wnereas customer positions and accounts are not.

Test 1

Test 2

Total

Number

average

Margin

firms

Deficiency

Average
Margin &
Clearing Fund
Deposit
Deficiency
($in thousands)

Average
Margin &
Average Clearing Fund
Margin Deposit
Deficiency Deficiency
($in thousands)

No.

NO.

Clearing Finns
Not carrying
inarjcet naxer
accounts

Clearing Fini
Carrying
warKet Maxer
accounts

793

316

462

Total

646

Accordingly, the Options Study recommends:

OCC SHOULD REVIEW ITS MARGIN AND CLEARING FUND
DEPOSIT RULES REGARDING OCC MEMBERS THAT CLEAR
MARKET MAKER ACCOUNTS WITH A VIEW TO DETERMINING
WHETHER IT WOULD BE APPROPRIATE TO INCREASE
THEIR MARKET MAKER MARGIN DEPOSIT REQUIREMENTS
IN ORDER THAT THE CLEARING FUND DEPOSITS OF
OCC MEMBERS THAT DO NOT CLEAR MARKET MAKER ACCOUNTS
ARE NOT UNREASONABLY SUBJECT TO THE RISKS OF THOSE
THAT DO CLEAR THESE ACCOUNTS.

b. Market Makers and Market Maker Clearing Firms
The Options Study obtained financial data with respect to both
market makers and OCC members carrying market maker accounts to determine
the actual impact of the April market surge on their financial condition.
Of the 22 OCC member firms which reported carrying market maker accounts,
eight carried approximately 1,250 of the 1,400 (87 percent) market
maker accounts. 33/ These eight firms each carried from 375 to
48 option market maker accounts.

While all 22 market maker clearing firms are subject to similar
risks and requirements, the failure of one of the eight largest firms
to honor its financial obligations would have the greatest financial
impact on the options market. For that reason, the Options Study
confined its analysis of the financial impact of the April market surge
to the eight largest market maker clearing firms.

Six of these eight OCC members were specialized market maker
clearing firms limiting their business almost exclusively to carrying

33/ Form A, appended as Exhibit 4.

647

options market maker accounts. In total, these six firms carried
approximately 1,000 CBOE and PSE market maker accounts (71 percent of
all market maker accounts) and only 36 non-market maker accounts, ^he
CBOE has been designated as the financial examining authority for all
six of these firms. The other two firms were integrated market maker
clearing firms carrying approximately 250 market maker accounts doing
business primarily at the AMEX and PHLX, and carrying approximately
36,000 customer accounts. The NYSE is the designated examining authority
for these two firms.

Because carrying market maker accounts was only a part of the
business of the two integrated firms, the adverse impact on their market
maker accounts of the April market surge had a far less drastic effect
on their net capital, as a percentage, than was the case for specialized
firms. Although one of the integrated firm's deductions to net capital
related to carrying market maker accounts increased from $3 million
on March 31 to $7.2 million on April 17, 1978, that firm's net capital,
in excess of that required, decreased only 13 percent. On the other
hand, the excess net capital of five of the six specialized firms
decreased by substantially larger percentages. Their net capital
decreases ranged from 42 percent to over 100 percent during the same
period, with two firms having net capital deficits.

The Options Study focused on the reasons that two of these eight
OCC members carrying market maker accounts had been unable to comply
with the Commission's net capital requirement as of April 17, 1973.

648

The rationale for concentrating on the firms most severely impacted
is that the Commission's net capital rule, in establishing minimum
financial standards, acts as a warning device to detect financial
problems at an early stage. In this regard, the experience of the
firms which encountered financial problems is the most relevant.
One of these firms, Firm A, had a net capital deficit of S800,000
on April 17, 1978, and the other, Firm B, had a net capital deficit
of $275,000. Both firms honored their financial obligations and
by the next day, April 18, were in compliance with the Commission's
net capital rule.

An analysis of the data with respect to these two firms shows that
their net capital difficulties resulted from several causes: (1) a
disproportionate concentration of an options class in the market maker
accounts carried by the clearing firm in relation to the total open
interest in that options class; (2) the net short positions in near
or at-the-money options; and (3) the high ratio of market maker net
capital deductions in relation to the OCC member's net capital.

The Options Study believes that each of the circumstances noted
above indicates special options risks. The recommendations discussed
below are necessary to better protect against the failure of an
OCC member carrying market maker accounts during periods of abnormal
market activity.

In addition, as discussed more fully below, the Options Study is
also recommending that the Commission's net capital rule be revised;

649

(1) to require that market makers maintain a minimum equity; (2)
to increase the deductions for options positions carried by a market
maker clearing firm for its own or an affiliated market maker account;
(3) to permit a market maker clearing firm one business day to obtain
additional capital or market maker equity resulting from stock or
options transactions in the market maker accounts it carries before the
net capital deduction resulting from options market maker positions are
applied; and (4) to reduce the net capital deductions for broker-dealers
trading both on and off the floor of an options exchange where appropriate,
to better reflect the risk limiting features of certain options
strategies.

5. RECOMMENDED CHANGES TO THE NET CAPITAL RULE
a. Concentrated Positions

Examination of all of Firm A's accounts at OCC showed that Firm A held
short positions that were not covered or hedged (uncovered short positions)
in its combined market maker account at OCC in 151 options classes.
Forty-eight of these uncovered short positions were equal to or in excess
of 10 percent of the OCC total open interest in the options class. In
41 of these 48 short positions Firm A's uncovered short position was in
excess of a 1000 contracts. In one class its uncovered short position
was over 17 thousand contracts.

The number of classes and the percentage of the total open interest
in an options class held in an uncovered short position in excess of a
1,000 contracts by the market maker accounts carried by Firm A were as
follows:

650

Positions in Excess of a Thousand Contracts

Percent of

open % % %

interest (less than 10%) 10-14 15-19 21-24 25-29 30 & over

Number of

classes 22 21 11 3 5 1

Ten market maker accounts carried by Firm A in the aggregate caused
a decline of almost $5 million in Firm A's net capital between April 13
and 17 , 1978. This decline was due to market maker losses in their options
positions and an increase in market maker equity requirements under the
net capital rule due to an increase in options premium values. A test
of these ten market maker accounts was performed to determine whether
the equity requirements for these market makers adequately comprehended
the potential loss between April 12 and April 17, 1978. This test assumed
that the positions held in these ten accounts did not change during the
test period so that the losses, if any, would have come about as the result
of price fluctuations. Of the 338 positions held in these ten accounts,
the market makers equity requirements exceeded the hypothetical loss in
289 instances. Market maker equity requirements were insufficient for
the remaining 49 positions. In 23, or almost half of these 49 positions,
Firm A's uncovered short position at OCC was in excess of 10 percent
of the OCC open interest in that class of options.

The Commission has long been concerned about the deductions that
should be made for large positions in a single security in computing net

651

capital. In 1972, in its proposal to adopt the net capital rule, the

Commission noted:

[It] has discovered a number of situations in
which either because there were a limited number
of market makers in a security or a broker-dealer
had an unusually large position in a particular
security, it became unlikely that such security,
given the existing market conditions, could be
sold at prices at or near the market price
quoted in a recognized inter-dealer quotation
system or exchange. 34/

To assure that a broker-dealer had sufficient capital when it
maintained large long or short positions, the Commission required an
additional deduction in computing net capital, equal to 50 percent of
that normally required, for proprietary positions in a single security
whose value exceeded 10 percent of a firm's net capital before the net
capital deductions on proprietary positions. 35/

Although this provision applies to both proprietary stock and
options positions, it does not apply to options positions in market maker
accounts guaranteed by a market maker clearing firm. The Options Study
believes that the same risks inherent in large proprietary options
positions also exist in options positions that are guaranteed by a market
maker clearing firm. A large options position however, should be defined
as a percentage of the open interest in the options class rather than
as a percentage of the clearing firm's net capital. The Options Study

34/ Exchange Act Release No. 9891 (December 5, 1972).
35/ SEC Rule 15c3-l(c) (2) (vi) .

652

believes, on the basis of the data that it reviewed, that any options

position in excess of 10 percent of the open interest in an options

class is an appropriate measure of a concentrated options position

in which clearing firm problems may be experienced due to sudden

price changes or in attempting to liquidate the position. An additional

net capital deduction equal to 50 percent of the deduction otherwise

required for each series in the concentrated options class is recommended

to recognize the additional risks of these positions.

Accordingly, the Options Study recommends:

THE COMMISSION SHOULD CONSIDER REVISING ITS
NET CAPITAL RULE TO REQUIRE AN ADDITIONAL CHARGE
IN AN OCC MEMBER'S COMPUTATION OF ITS NET CAPITAL
FOR ANY NET LONG OR NET SHORT OPTIONS POSITIONS
IN ALL MARKET MAKER ACCOUNTS GUARANTEED BY THE
OCC MEMBER WHICH ARE IN EXCESS OF 10 PERCENT
OF THE OPEN INTEREST IN THE OPTIONS CLASS.
THIS DEDUCTION SHOULD BE EOUAL TO AN ADDITIONAL
50 PERCENT OF THE CHARGE OTHERWISE REQUIRED
FOR EACH SERIES IN THAT OPTIONS CLASS.

b. Short Positions In Near Or At-the-Money Options
The Options Study examined 734 active market maker accounts as
of April 14, 1978, and compared the market maker equity requirements to
the loss in equity in the accounts, if any, between April 14 and April 17,
1978. Of the accounts examined, only 47 had losses in excess of the
equity requirements. Although the positions could have changed during
April 17, and additional equity may have been deposited to their accounts
by some market makers, the Options Study is satisfied that the market

653

maker equity requirements generally provide adequate capital protection
except for short positions in near or at-the-money options.

The price movement of near or at-the-money options series are
generally more volatile than those of other series of a given options
class and because of the leverage characteristics of options, substantial
percentage changes in the options premium value can result from related
small price changes in the underlying stock. For example, during the
April market surge, with a five to eight percent change in the price of the
underlying security, the premium value for Dupont April 110s increased
approximately 4,300 percent; IBM April 240s approximately 1,005 percent;
Disney April 35s approximately 633 percent; and Digital Equipment April
40' s approximately 483 percent.

Most of the potential loss in the ten market-maker accounts carried
by market maker clearing Firm A which created the greatest capital
deductions to that firm was due to short positions in near or at-the-
money options.

Currently, the Commission's net capital rule requires that a market
maker have equity equal to 75 percent of the premium value of short option
contracts trading at $100 per contract and above and $75 for those contracts
trading at less than $100, or the OCC member firm carrying the market maker
accounts must deduct the deficiency in computing its net capital. In view
of the extremely volatile price changes that can occur in near or at-the-
money options positions the Options Study believes that this requirement

40-940 O - 79 - 44

654

is insufficient with respect to such positions. The rule should be
revised to better reflect the more volatile percentage price movements
that can occur in near or at-the-money options. On the basis of
the data that it reviewed, the Options Study believes that the net
capital requirement can be made more sensitive to the risks of near
or at-the-money options, by requiring that market makers have equity
for such positions equal to the greater of (1) 75 percent of premium
value, (2) $75, or (3) 5 percent of the market value of securities
underlying uncovered short options positions, reduced by the amount
the options exercise price is in or out-of-the-money to recognize
that as an option moves into or out-of-the-money its volatility,
measured as a percent of price, decreases.

In the ten accounts carried by Firm A described above, the market
maker equity requirements for 49 positions was $1.4 million as of April
12, 1978. The hypothetical loss in these positions between April 12
and April 17, 1978 was $2.6 million, or a net loss in excess of the market
maker equity requirements of $1.2 million. The bulk of this hypothetical
loss, however, was accounted for by 19 positions which had losses in
excess of $10,000 of their equity requirements. The equity requirements
for these 19 positions were $1.1 million compared with a hypothetical
loss of $2.2 million, or a net loss in excess of $1.1 million of the equity
requirements. Had these 19 positions been required to maintain equity

655

in accordance to the requirements recommended by the Options Study

described above the total equity requirement for these 19 positions would

have been increased by $900,000 to a total of $2 million and accordingly

the hypothetical loss not covered by equity requirements in these 19

positions would have been reduced from $1.1 million to $200,0fiQ.

Accordingly, the Options Study recommends:

THE COMMISSION SHOULD CONSIDER REVISING ITS
NET CAPITAL RULE TO INCREASE THE DEDUCTION
IN COMPUTING NET CAPITAL FOR NEAR OR
AT-THE-MONEY OPTIONS BY PROVIDING THAT
THE DEDUCTIONS FOR SHORT OPTIONS POSITIONS
IN MARKET MAKER ACCOUNTS BE EQUAL TO
THE GREATER OF (i) 75 PERCENT OF THE PREMIUM
VALUE, (ii) $75, OR (iii) 5 PERCENT OF THE
MARKET VALUE OF THE UNDERLYING STOCK REDUCED
BY THE AMOUNT BY WHICH THE EXERCISE PRICE OF
THE OPTION VARIES FROM THE CURRENT MARKET
PRICE FOR THE STOCK.

c. Restriction on Volume of Business Carried
As explained above, the Commission's net capital rule re-
quires a market maker clearing firm to reduce its net capital to the ex-
tent that the deductions required under the rule with regard to the
positions in a market maker account (equity requirement) exceed the
equity in that market maker account. The rule further provides that
these gross deductions, calculated by the market maker clearing firm
to determine the equity requirements in all of its market maker accounts,
may not exceed 10 times its net capital for a period exceeding five
consecutive business days. During these five business days, the market

656

maxer clearing firm can increase its capital, or call upon its market

maKers to reauce their positions or deposit additional equity to reduce

tne direct deductions against tne marKet maker clearing firm's net capital,

Tnis provision of the net capital rule was adopted to restrict the amount

ol options market maxer business a clearing firm could conduct based

on its level of capitalization. During the period just prior to April

14, 197b, all eignt of tne CXX member lirms carrying most of the marKet

maKer accounts were in compliance with this provision and only two

maintained ratios in excess of five times their net capital. These two

carrying firms were the same firms that failed to comply with the

Comuiiss ion's net capital rule on April 17, 1978. If each of these

tirms hao been required to maintain a ratio of deductions of less

tnan five times its net capital prior to the April market surge, Firm A

would nave been required to have had additional capital of $3,000,000,

and Firm b would have been required to have had additional capital

of $700,000. Because of these findings, the Options Study believes

tnat tne currently allowable ratio of deductions to net capital permits

UCL memoer firms to carry an excessive amount of market maker business

and tnat this ratio should be reduced.

Accordingly, the Options Study recommends:

THE COMMISSION SHOULD CONSIDER REVISING ITS
NET CAPITAL RULE TO REDUCE THE PERMISSIBLE
AMOUNTS OF GROSS DEDUCTIONS TO NET CAPITAL,

657

RESULTING FRL>i THE OPTIONS AND STOCK POSITIONS
CARRIED BY A CLEARING FIRM FOR MARKEr MAKERS.

d. Market Maker Minimum Net Capital

Tne iy75 Amendments to the Exchange Act contemplated that the

Couiuission would adopt financial responsibility requirements for all

DroKer-dealers . Prior to the Commission's adoption of its net capital

rule in 1975 , oroker-dealers which were subject to the financial

requiraiients estaoiished by a national securities exchange were exempt

from tne Commission's financial requirements. When the Commission

amended its net capital rule in 1975, all broker-dealers became subject

to tnis rule except specialists, including market makers wnich did

not carry customer accounts. In announcing the amendments to the

net capital rule, tne Commission stated:

Tne rule as adopted separately classifies
stocK excnange specialists wno do not deal with
otner than members, orokers or dealers and certain
specialists and marxet makers in options under
specified circumstances and exempts such classes
from tne rule. Tne rules, settled practices and
applicable regulatory procedures of the American
Stocx Exchange, Boston stocx Exchange, Midwest
btocx Excnange, New Yorx Stock Exchange, Pacific
Stock Excnange, PBW Stock Exchange [Philadelphia
Stock Excnange] and the Chicago Board Options
Excnanye are satisfactory to the Commission to
permit the separate classification of such market
maxers and specialists and their exemption from the
provisions of the rule.

658

It should be noted, however, that Section
15(c)(3) of Securities Exchange Act of 1934 ("the
Act") requires the establishment of minimum financial
responsibility requirements for all brokers and
dealers. The application of financial responsibility
requirements to specialists present unique questions
which are still being explored by the Commission
and while the alternative approach adopted today
appears to be a possible solution to this question,
the Commission believes further study is warranted.
The Commission expects to conclude its review as
promptly as practicable. 36/

In particular, the Commission noted in its release:

The rule requires specialists, market makers,
and registered traders in options who either transact
business with other than members, brokers or dealers
or who are clearing members of the Options Clearing
Corporation ("OCC") to comply with the basic
provisions of the net capital rule as they relate to
options. However, the rule will continue to classify
separately and exempt market makers and specialists who
are not clearing members of the OCC and who do not
transact a business in securities with other than
members, brokers and dealers. In that connection, the
rule incorporates specific net capital treatment
for brokers and dealers carrying the accounts of
such options specialists, market makers, and reg-
istered traders. The Commission anticipates that
market maker, specialist and registered trader
capital requirements will be amended periodically
to provide for modifications of those requirements
as the option market may evolve. 37/

It has been argued that market makers would perform better and
possibly more conservatively if their own capital were at stake in
their transactions. It has also been contended that if market makers

36/ Exchange Act Release No. 11497 (June 26, 1975).
37/ Exchange Act Release No. 11497 (June 26, 1975).

659

had a minimum capital requirement, they would be less dependent upon,
and thereby less likely to be subject to the direction of, their
clearing member. In September 1977, the Division of Market Regulation
recommended to the Commission that it approve for public comment
certain proposed . amendments to the net capital rule which would
have required those market makers that were exempt from the Commission's
rule to maintain net capital of $25,00p.

This proposed rule was not published for comment, in part because
the Commission lacked statistical data to determine its possible impact
on the options market. The Options Study has since found that on March
31, 1978 (before losses were incurred during the April market surge),
498 of the 865 active market makers on all options exchanges had less
than $25,000 equity in their accounts. Of these, 279 had less than
$5,000 equity in their accounts.

An analysis by the Options Study and the CBOE of the market
maker accounts carried by the two market maker clearing firms
which experienced capital deficiencies under the Commission's
net capital rule during the April market surge, did not indicate
that a $25,000 minimum financial responsibility standard need be
required. The deficiencies experienced by Firm A and Firm 3 referred
to above, were not caused by market maker accounts holding only
small amounts of equity.

660

Firm A's adjusted net capital declined between April 13 and 17,
1978, by approximately $7,000,000. At the time Firm A carried 173
market maker accounts. At Firm A, ten accounts caused almost $5,000,000
of this decline; 15 accounts caused an aggregate decline of about
$5,750,000; and 20 accounts caused an aggregate decline of more than
$6,300,000 or approximately 87 per cent of the firm's net capital
decrease between Aprif 13 and 17. Of the ten accounts causing Firm
A's greatest net capital decline, five had equity in excess of $1,000,000
on April 12, four had equity in excess of $250,000, and one had
equity in excess of $70,000. Accounts having an equity of $100,000
or more on April 12 were the cause of more than 92 percent of the
firm's net capital decline, and accounts with equity of less than
$25,000 were the cause of less than one percent of its decline.

Firm B's adjusted net capital declined between April 13 and 17,
1978, by approximately $1,800,000 of which approximately $1,300,000
was caused by ten accounts. All but two of the ten accounts had
equity on April 12 in excess of $25,000 and all but four in excess of
$50,000. For the firm as a whole, 70 percent of the net capital decline
was caused by accounts having equity on April 12 in excess of $25,000.

In view of the directives contained in the 1975 amendments to the
Exchange Act, however, the Options Study believes that market makers
should be required to have a minimum equity, similar to the amount re-
quired under the Commission's net capital rule for other broker-dealers
not carrying public customer accounts, currently $5,000. The Options

661

Study believes this requirement will add financial responsibility to the

options market maker system without unnecessarily impeding entry into

the business.

Accordingly, the Options Study recommends:

THE COMMISSION SHOULD CONSIDER REVISING ITS
NET CAPITAL RULE TO REQUIRE MARKET MAKERS
THAT DO NOT CARRY CUSTOMER ACCOUNTS OR CLEAR
TRANSACTIONS TO MAINTAIN A MINIMUM EQUITY OF
$5,000.

e. OCC Members and Their Affiliates that are Market Makers
In June 1977, the Commission's net capital rule was amended with
respect to OCC members which limited their business to acting as market
makers for their own accounts and to the carrying of the accounts of other
market makers. 38/ As modified, the rule permits these firms to apply the
same limited net capital deductions to their options and stock positions
as those required to determine the market maker equity requirements for
market makers accounts being cleared through an independent firm.
Prior to this amendment, such positions were subject to the more
stringent net capital deductions for options positions held by upstairs
dealers. For example, an upstairs dealer is required to make a net
capital deduction equal to 30 percent of the value of the underlying
security on the sale of an uncovered option whereas a market maker
is required to have equity of 75 percent of the premium value of
a short option with a minimum of $75 per options contract.

38/ Exchange Act Release No. 13623 (June 13, 1977).

662

The options and stock positions of the market makers carried
by an independent firm are subject to arm's-length negotiated review
which include; (1) hedge analysis; (2) review of the size of uncovered
short positions; (3) net capital requirement impact; and (4) in
sane cases, the firm's knowledge of the ability of the market maker,
as part of the firm's effort to protect its financial interest
as a creditor of the market maker accounts it carries. This safeguard,
however, is lacking when a clearing firm is trading in options on
the floor of an exchange for its own account or is clearing an account
in which an affiliated person has an ownership interest. A market
maker clearing firm trading for its own account, or carrying an
account in which an officer or partner or employee of the clearing
firm has an ownership interest, may not apply the same day-to-day
review and risk management techniques to such an account as would
normally be applied to an independent market maker account.

The Options Study has learned of instances in which a principal
officer of a clearing firm has a direct ownership interest in market
maker accounts. In one instance, the market maker account would have
had a liquidating deficit without the principal officer's contribution
to the account. Another example involved a market maker clearing firm
which maintained an approximate one-third interest in a market maker
account. When this account caused a $3.7 million deduction in computing
the market maker clearing firm's net capital, resulting in a net capital
deficiency of about $480,000, it became necessary to liquidate the account

663

to eliminate the net capital deficiency. It is questionable whether an

independent OCC member firm would have been willing to carry the positions

that resulted in a loss of this magnitude.

Accordingly, the Options Study recommends:

THE COMMISSION SHOULD CONSIDER REVISING ITS
NET CAPITAL RULE SO THAT THE CAPITAL REQUIRED
FOR ALL OF THE POSITIONS IN AN ACCOUNT IN WHICH
A CLEARING FIRM, ITS OFFICERS, PARTNERS, DIRECTORS
OR EMPLOYEES MAINTAIN A FINANCIAL INTEREST ARE
INCREASED. THIS MAY BE ACCOMPLISHED BY REQUIRING
THAT SUCH ACCOUNTS MEET THE SAME FINANCIAL REQUIRE-
MENTS THAT ARE APPLICABLE TO UPSTAIRS DEALER FIRMS.

f . Immediate Charges to Carrying Firm Under the Net Capital Rule
The net capital deductions that result from stock and options trans-
actions in market maker accounts carried by a market maker clearing firm
must be made on the same day the transactions occur although these trans-
actions do not clear until the next day. While this requirement was adooted
in recognition that options transactions clear the next business day, it
results in a market maker clearing firm having to maintain a net capital
position in anticipation of these charges and can impose a significant burden
on the market maker clearing firm. For example, during the April market
surge the total charges to market maker clearing firm net capital increased
from an aggregate of $12.3 million on April 13, 1978 to S21 million on
April 17 and then dropped back to $15.8 million on April 18, and $11.6
million by April 24, 1978. 39/

39/ Table No. 7 apppended as Exhibit 6,

664

Usually, the net capital deduction for other securities trans-
actions by broker-dealers is not made until the day the transaction
normally clears ("settlement date"). For example, no charge is made
to net capital on the purchase of a stock by a broker-dealer until
the settlement date, generally, five business days after the purchase.
The Options Study believes that market maker clearing firms should have
until the next business day after their market maker transactions occur
— the day the transactions normally clear — to put additional capital
into the f irm or to obtain additional capital from market makers whose
accounts they carry. This change in the net capital rule would not relieve
a market maker which does not clear his own transactions from his responsi-
bility to have equity in his account at the end of each day.

While this recommended change may have the effect of reducing
the amount of net capital market maker clearing firms must maintain
on a regular basis, other recommendations of the Options Study described
above will increase their net capital requirements and affect the
timing of net capital deductions to make them more sensitive to
particular options risks.

Accordingly, the Options Study recommends:

THE COMMISSION SHOULD CONSIDER REVISING ITS
NET CAPITAL RULE TO PERMIT A MARKET MAKER CLEARING
FIRM ONE BUSINESS DAY TO OBTAIN ADDITIONAL CAPITAL
OR MARKET MAKER EQUITY BEFORE MEETING THE NET
CAPITAL DEDUCTIONS ARISING CUT OF ITS MARKET
MAKER CLEARING BUSINESS.

665

g. Conversion - Reverse Conversion Positions
The net capital rule as it applies to OCC members carrying market
maker accounts recognizes that the combination of certain stock and
options positions and certain multiple options positions reduces the
risk associated with each separate position. Accordingly, the equity
requirements for offsetting stock and options positions (hedges), long
options versus short options positions (spreads) and offsetting
positions in puts and calls (straddles) are lower than the aggregate
requirements would be for each separate component of such combinations.
The risk limiting nature of certain other options combinations,
however, are not currently recognized in computing the equity requirements
for market makers. These combinations include a put, a call and
the underlying stock, or offsetting options positions that are equivalent
to long or short stock positions.

A short call, long stock and long put position (generally called
a conversion position) or a long call, short stock and short put (a
reverse conversion position) limits the loss or profit to a fixed amount
when both the put and the call have the same exercise price and expiration
date. The same risk limiting effect is true of options conversion
equivalents, that is, one put and call position with the same exercise
price and expiration date offset by another put and call position which
has the same expiration date as the first but a common exercise price which
is different from the first. Although the Commission's net capital rule

666

recognizes the risk limiting nature of a conversion or reverse conversion

position in computing the net capital requirements for upstairs dealers

trading off the floor of an exchange, they are not recognized in the net

capital rule with respect to computing the equity requirements for market

makers.

The net capital rule for OCC market maker clearing firms currently

requires in a conversion position that the call offsetting the stock be

treated as a hedge and the put treated as an uncovered position and that

the options conversion equivalent be treated as two separate spreads.

This treatment often results in a deduction in computing net capital that

is in excess of the maximum possible loss on these options positions. For

example, in the following position the maximum loss is $187.50, but the

equity requirement for the market maker holding the position currently would

be $1,047 based on the assumed premium and market values shown. If the same

position was held by an upstairs dealer the net capital deduction would

be $187.50.

Premiums Current

Received Equity

(paid) Requirement

"$ $
Put sell 1 JAN 280 a 12-5/8 1262.50 946.88

Call buy 1 JAN 280 (3 13-1/2 (1350.00)
Stock sell 100 IBM (? 279 27,900.00 100.00

Net Equity Reguirement $1046.88

66;

Accordingly, the Options Study recommends:

THE COMMISSION SHOULD CONSIDER REVISING ITS
NET CAPITAL RULE TO LIMIT THE NET CAPITAL
DEDUCTION FOR MARKET MAKER OPTIONS CONVERSION,
REVERSE CONVERSION OR EQUIVALENT CONVERSION
POSITIONS TO THE MAXIMUM POSSIBLE LOSS ON THESE
POSITIONS PROVIDED THAT IN BOTH CASES THE OFF-
SETTING PUT AND CALL OPTIONS HAVE THE SAME EXERCISE
PRICE AND EXPIRATION DATE AND ARE TRADED ON
AN EXCHANGE.

h. Financial Requirements of Upstairs Dealer Firms
The financial requirements applicable to the options business of
upstairs dealers that trade off the floor of an exchange are substantially
different from those established for an OCC member carrying market maker
accounts. The requirements for the market maker clearing firms' short
options positions recognize that a liquid market exists where listed options
are bought and sold at regularly quoted prices. The parallel requirements
for upstairs dealers, on the other hand, are based on the assumption
that no secondary market for the options exists and that the options
will inevitably be exercised.

In computing net capital the Commission's net capital rule currently
requires upstairs dealers to:

— Treat premiums received for writing transactions
as income;

— Treat the cost of acquiring options positions as
an expense;

— Maintain net capital on the basis that options positions
will be exercised.

668

The Commission explained its net capital treatment for options

positions held by upstairs dealers and the net capital deductions

(haircuts) that resulted from this treatment as follows:

These haircuts follow existing industry practice;
the Commision believes, however, that it is appro-
priate to review on a continuing basis the level of
haircuts to be applied to options positions and to
make future adjustments as more experience is gained
with the operation of option markets. In particular,
the provisions with respect to haircuts on long
options may be reviewed to establish an appropriate
relationship between haircuts applied to the
securities underlying options and the relatively
higher volatility of options compared to the
underlying security. 40/

The existing indu.-try practice referred to by the Commission had
been developed with respect to conventional options traded in the over-
the-counter market prior to listed options trading. When these net capital
requirements were being analyzed the development of a listed options
market was still uncertain. 41/ The Options Study compared the impact
of the current requirements for upstairs dealers with those that
would result from basing the net capital deductions on the requirements
applicable to market maker clearing firms.

The Options Study has concluded that the current net capital
deductions for the upstairs dealer do not reflect the risk limiting
feature of certain options strategies nor the effects on risk of

40/ Exchange Act Release No. 11497 (June 26, 1975).

41/ The Commission's first proposal to adopt a uniform net capital
rule was published on December 5, 1972, Exchange Act Release
No. 9891 (December 5, 1972).

669

a secondary trading market. The current assumption underlying the net
capital rule as applied to upstairs dealers, that the options will'
be exercised, is no longer valid. Of the 22.4 million CBOE traded
option contracts purchased by public customers and firm proprietary
accounts which had a 1977 expiration date, only 1.1 million, or
5.1 percent, were exercised. 42/

The disparate treatment accorded upstairs dealers as compared
to OCC market maker clearing members was shown in one example given
by an upstairs dealer where the capital requirement for his options
positions was $526,400 compared with $146,700 had the same positions
been subject to the market maker requirements. 43/ Another upstairs
dealer showed that his options positions were subject to a $392,552
net capital requirement compared to a $66,018 net capital requirement
if these same positions had been held in a market maker account. 44/

This difference in the net capital requirements for options positions

held by upstairs dealers and in market maker accounts can be demonstrated.

by the following hypothetical options spread:

Premiums
Options Position Received or (Paid)

Long 1 July 30 ? 8 ($800) Underlying Stock

selling a 35.
Short 2 July 35 9 5 $1,000

Long 1 July 40 3 3 ($ 300)

42/ The Chicago Board Options Exchange, "Market Statistics", 1978.
43/ Letter from Wedbush, Noble, Cooke, Inc., dated August 10, 1976.
44/ Letter from Kaufmann, Alsberg & Co., dated April 21, 1977.

40-940 O - 79 - 45

670

This type of position, generally called a "butterfly spread" involves

the simultaneous purchase and sale of options in the same class, with the

same expiration date, so that for every two options the broker-dealer sells

(at the same striking price), he purchases two options - one in the price

series below, and one in the price series above, the price series at which

the options are sold. The spread is a thoroughly hedged position

in which the most that can be lost ( if the spread position is held to

expiration) is the difference between the amount received from the sale

of the options and the amount paid to purchase the options (S1100-S1000

or $100 in the above example). The loss would occur if, at expiration,

the stock sold at 30 or less, in which case all the options would be

worthless, or at 40 or above, in which case the dollar gain from each

of the two long postions would be offset by the dollar loss from each

of the two short positions. The profit and loss on the above butterfly

spread at different stock price levels is shown in the following table.

Below
Price of Stock 303031323334353637383940 41*

Val. of Jul 30s 0 0 1 2 3 4 5 6 7 8 9 10 11

Val. of Jul 35s 0 0 0 0 0 0 0 12 3 4 5 6

Val. of Jul 40s 0000000000001

Profit/Loss:

Long 1 July 30 -8 -8 -7 -6 -5 -4-3-2-1 0 1 2 3

Short 2 July 35s +10 +10 +10 +10 +10 +10 +10 +3 +6 +4 +2 n -2

Long 1 July 40 -3 -3 -3 -3 -3 -3 -3 -3 -3 -3 -3 -3 -2

Net Profit/Loss -1-1012343210
* Net profit/loss at all prices above 40 will be -1.

671

Tne current net capital rule as applied to upstairs dealers makes
no allowance tor such spreads. Instead of treating the entire spread
as a unit, tne current treatment under tne net capital rule only allows
consideration lor two elements ol a spread position. In the above example,
tne butterlly spread ot one long July 30, one long July 40 and two short
Juiy 35s is treated as two separate spreads, consisting of two elements
eacn:

Spread I: one long July 30; one short July 35
Spread II; one long July 40; one snort July 35.

Treated separately "Spread I", has a maximum three point risk of
loss it tne stocK sells at 30 or below at expiration and "Spread II"
nas a maximum three point risk of loss it the stock sells at 40 or above
at expiration. Under tne current net capital rule the combined risk
or loss frau "Spread I" and "Spread II" is six points and the net capital
deduction is $fc>00. wnen Spread I and Spread II are combined as a butterfly
spread, nowever, the total risK ot loss is only one point ($100) regardless
ot tne underlying stock price, as shown in the above table. A net capital
cnarge ot $6U0 in lignt ot tne $100 at risk is excessive. Moreover,
it snouid oe noted that had tne same position been in a market maker account
it would be suoject to a $50 equity requirement since the market maker

672

requirement is based on the net long or net short value of this position

The total long value is 11 (1 July 30 @ 8 plus on July 40 @ 3) and the

short value is 10 (2 July 35s @ 35) for a net long value of 1. As

previously explained this net long value would be subject to a 50

percent requirement or $50, One upstairs dealer commented to the

Options Study on the net capital requirements as follows:

[W]here new capital cannot be easily raised, it is incumbent
upon the SEC to see that its rules permit the full utilization
of existing capital. Unfortunately, this is not presently the
case. Although many instances where rules requiring capital
in excess of that needed for prudent business reasons can
be cited, I will limit myself to two examples both involving
option arbitrage. Both of these deal with the net capital
treatment of certain types of option positions by firms other
than exchange market makers. The Commission has encouraged
and indeed has made it easier for market makers on the floor
of the exchanges to utilize their capital more freely. We
fail to see why those firms which are not acting as market
makers on the floor, but have chosen to provide liquidity
as upstairs traders and arbitrageurs are inhibited by net
capital rules which treat their positions much more
restrictively. 45/

Based on its study of the equity requirements of some 870 market

maker accounts during the April market surge the Options Study believes

that the net capital requirements applicable to market maker clearing

firms and market makers provide an appropriate foundation upon which

to develop appropriate net capital requirements for options positions

held by upstairs dealers. The provisions applicable to firms carrying

market maker accounts, however, take into consideration certain

day-to-day early warning and control devices, assume an arm's-length

45/ Letter from Oppenheimer & Co., Inc., dated July 12, 1978.

673

review by an independent clearing firm, and recognize the limitation on
the amount of market maker business a clearing firm may carry. The
proprietary options positions held by upstairs dealers, are not subject
to these controls. Accordingly, any revision to the net capital rule
to recognize the Limitation on risks of options combinations and options
spreading strategies in the accounts of upstairs firms should provide
for greater net capital requirements than are currently required for
market maker accounts which are subject to these controls.

Although the approach to the options net capital requirements for
upstairs dealers should be the same as that applicable to market maker
clearing firms, the Options Study believes that the deduction for all
short options positions not hedged by stock should be 150 percent of
the market value of the options because there is no day-to-day early
warning and control device or arms-length review by an independent
firm as there is with respect to the market maker accounts carried by
an independent market maker clearing firm. For the same reasons, if such
options positions are not offset by other options positions, the net capital
deduction should be five percent of the market value of the underlying
stock, or 150 percent of the options market value, whichever is greater.

Accordingly, the Options Study recommends:

THE COMMISSION SHOULD CONSIDER REVISING ITS

NET CAPITAL RULE TO ESTABLISH REQUIREMENTS

FOR UPSTAIRS DEALERS THAT TAKE INTO CONSIDERATION

THE EFFECTS ON RISK OF SPREADING STRATEGIES

IN LISTED OPTIONS AND THE EXISTENCE OF A

SECONDARY MARKET IN OPTIONS.

674

OPTIONS SPECIALIST STOCK CREDIT

The Federal Reserve Board ("FRB") and the self -regulatory
organizations have adopted margin regulations governing the amounts
which broker-dealers may lend in connection with securities transactions
and holdings. The Options Study is recommending that certain revisions
of these regulations be made to enable options market makers to
better use stock to hedge against the risks they incur in maintaining
an options market in a manner which, at the same time, would prevent

options market making credit from being used to speculate in stock
underlying options.

Regulation T of the FRB's margin requirements prohibits a broker-
dealer from financing more than a specific percentage — currently 50
percent — of a customer's initial purchase of an eligible equity security.
In addition to the FRB's initial requirements, the self -regulatory
organizations have adopted their own minimum margin maintenance rules
to assure broker-dealers a degree of protection should the customer's
securities positions they finance decline in value. These margin maintenance
requirements provide that the customer must at all times maintain on
deposit with the broker-dealer, cash or securities having a value at
least 25 percent greater than the amounts borrowed from the broker-dealer
by the customer. As a result, broker-dealers generally retain collateral
in the form of securities with a value equal to or exceeding 133 percent
of the amount extended to customers to finance their holdings of securities
on margin.

675

The FRB margin requirements were originally adopted in 1934 because
of Congressional and FRB concern, that grew out of the 1929 stock market
decline, with (1) securities speculation; (2) the large amount of loans
outstanding to finance securities purchases compared to total loans extended
by banks; and (3) the amount of the nation's credit being used to finance
securities purchases and holdings. As a result of the rapid expansion
of credit in other segments of the economy since 1929, the amount
of credit extended to finance securities purchases and holdings now
are less than one percent of all outstanding credit, as compared to
35 percent in 1929. But the regulation of margin is still considered
important (1) to help prevent customers from over-extending their financial
resources, (2) to prevent broker-dealers from becoming financially
vulnerable to customer credit risks, and (3) to limit speculation
in the securities markets.

Before trading began in listed options, the margin requirements for
options were established by the various national securities exchanges.
In early 1973, after listed option trading began, the Commission, at
the request of the FRB, included options within its "Definition of the
Term Equity Security" in Rule 3a 11-1, under the Exchange Act. hereafter,
the FRB amended its margin regulations to (1) prohibit broker-dealers from
providing any credit for the purchase of options; (2) prohibit the use of
margin required on the sale of uncovered options from also being used as
margin to purchase other securities; and (3) include options under its credit
regulations applicable to bank loans secured by securities, FR3 Regulation U.

676

No margin is required on the sale of an option if the option
is covered by the customer's underlying stock position. Beginning
January 1, 1976, the FRB required broker-dealers to obtain a margin
deposit for uncovered short options positions equal to 30 percent
of the market value of the underlying security increased by the amount
the option was in-the-money and decreased by the amount the option was
out-of-the-money, with a minimum requirement of $250. The proceeds
of the sale of the option may be used toward meeting this margin
deposit requirement.

1. SPECIALIST ACCOUNTS

Broker-dealers maintaining a market on the floor of a national
securities exchange are subject to different margin regulations than
those described above. A broker-dealer which is engaged in maintaining
a market on the floor of a national securities exchange may maintain
a separate "specialist account" in which are carried all transactions
resulting from his market making activities. The maximum loan value
of specialist securities carried in the specialist account, including
any margin securities deposited in that account, may be determined
by a creditor of the market maker in the creditor's own good faith
judgment. As long as the market value of the securities in the
account exceeds the liabilities in the account — that is, as long
as the specialist account liquidates to a positive equity balance
rather than to a deficit — the market maker is not required by FRB

677

regulations to make any margin deposit to the account. Any securities
transaction by a market maker which is not in accordance with his
market making responsibilities, however, does hot qualify for this special
margin treatment and must be carried by the market makers' creditor in a
separate general account subject to the FRB's current 50 percent margin
requirement applicable to customers generally.

The FRB has never defined the range of market making transactions
eligible for good faith credit under its margin regulations. Instead it
has relied on the definition of these responsibilities contained in the
Exchange Act, Commission rules and regulations, and the rules of the national
securities exchanges which register market makers as specialists.

The Commission's Rule llb-1, "Regulation of Specialists", under the
Exchange Act, provides that a national securities exchange may permit an
exchange member to register as a specialist, as long as the rules of that
exchange require the specialist to (1) maintain adequate minimum capital;
(2) assist in the maintenance of a fair and orderly market in the course
of its dealings for its own account; (3) restrict his dealings to those
reasonably necessary to maintain a fair and orderly market, and (4) con-
form to general exchange provisions setting out the responsibilities
of a specialist. In addition, the national securities exchanges must
have procedures for the effective surveillance of the specialist's
activities. 46/

46/ 17 CFR 240.11b-l (1977).

678

Under these guidelines the CBOE, the PSE and the MSE designated their
competing options market makers as "specialists". The AMEX and PHLX
designated as "specialists" their unitary specialists in options as well
as other members dealing for their own account on the floor with
specified market making obligations, referred to by these exchanges as
"registered options traders".

2. GOOD FAITH CREDIT

When trading in listed options began, certain of the options
exchanges believed that a transaction by an options market maker
in the underlying stock to hedge a market making options position
was eligible for good faith credit. These exchanges permitted their
clearing firms to finance these stock transactions on a good faith
credit basis. The staff of the FRB disagreed and the FRB proposed
to amend its rule governing credit for exchange specialists and
market makers, first in December 1976, and later revised in April
1977.

Under the FRB April 1977 rule proposal an options market maker
is eligible to obtain good faith credit for the following securities
positions:

— All option positions resulting from transactions
executed on the floor of the exchange where the
market maker is registered as a specialist.

— All margin securities deposited in
the market maker's specialist account.

679

Although the proposed amendments have not been adopted, the Commission
has permitted OCC clearing firms to finance the market maker accounts
they carry in accordance with the April 1977 FRB rule proposal
as if it were in effect. 47/

The options market maker must deposit 25 percent margin for the
following securities:

— Stock acquired to hedge an options position
provided that there is no offsetting options
position to the option position hedge and
the option is not out-of-the-money by more
than 5 percent.

The options market maker has five business days in which to deposit
additional margin or liquidate a stock position in the following circum-
stances:

— A stock position acquired as a bona fide hedge
becomes ineligible as a bona fide hedge (1) because
of a move in the stock price which results in the
hedged option being out-of-the-money by more than

5 percent, or (2) because the market maker acquires
an options position which offsets the options position
that is hedged with the stock (unless the stock again
becomes a bona fide hedge under this definition
during the next five day period). If the stock is
not liquidated and the market maker had made an initial
margin deposit of 25 percent, the additional margin
required is 25 percent of the then market value of
the stock.

— The market maker exercises a long options position or
is assigned an exercise notice against a short options
position.

47/ Letter to John T. McLoughlin, Vice President, AMEX, dated June 20,
1977, with copies to other securities exchanges.

680

— The market maker acquires stock underlying an option
listed on the exchange where the market maker is
registered as a specialist, and the acquisition is
made while the market maker is on the floor of that
exchange.

If a market maker engages in options transactions from off
the floor of the exchange where the market maker is registered as
a specialist, including transactions in dually listed options on
another exchange, the options market maker is treated as a public
customer and required to meet public customer margin requirements,
except for transactions to close out an open options position.

The options market maker need meet only the FRB initial margin
requirements with respect to his transactions and is not required to
meet options exchange margin maintenance requirements as long as his
account does not liquidate to a deficit. If the market maker's specialist
account liquidates to a deficit he must eliminate that deficit by the next
business day under the FRB April 1977 proposal.

Stock specialists are eligible for good faith credit on their
specialist stock positions. The FRB April 1977 proposal requires stock
specialists who are permitted to use options to hedge their specialist
positions to deposit margin of 25 percent of the purchase price of the
option.

3. FREE-RIDING AND BONA FIDE HEDGING

The practice of acquiring a stock position and liquidating it
within five business days without making a required margin deposit is

681

called "free-riding". The FRB does not prohibit free-riding but all
self-regulatory organizations have adopted rules which prohibit their
broker-dealer member firms from permitting a public customer to
engage in free riding. These self -regulatory organization regulations,
however, have not been applied to market maker stock transactions.
For that reason, an options market maker has five business days
within which to liquidate a stock position without making any margin
deposit when the stock was originally acquired as a bona fide hedge
of an options position.

Some options market makers have made a practice of selling their
stock within this five day period and then immediately repurchasing
the stock to retain their stock position to avoid the necessity of putting
up a margin deposit. This practice permits the options market maker to
speculate in the stock underlying an option without being required to
maintain a margin deposit and tends to create artificial volume in the
stock markets to avoid maintaining a margin deposit. The Options
Study does not believe that this type of activity contributes to
an orderly market or to the financial integrity of the options market.
Nevertheless, the Options Study understands that this practice is
engaged in by some market makers for hedging purposes and is done
to circumvent the restrictive FRB April 1977 proposal that permits
a reduced 25 percent margin deposit for only those stock hedges
which offset options that are five percent or less out-of-the-money.

682

Permitting a market-maker reduced margin only if stock is used
to hedge an options position which is out-of-the-money by no more than
five percent has been strongly criticized by the options exchanges because
it restricts the ability of options market makers to use stock to hedge
the risks of out-of-the-money options positions. This limitation also
affects stock positions initially eligible for the reduced margin
treatment because the market maker is required to increase the margin
deposit to 50 percent, or to liquidate the stock position, if, either
during the remainder of a day or at a later date (1) stock price movements
results in "hedged" options becoming more than five percent out-of-the-
money or (2) the "hedged" options are offset by other options acquired
by the market maker.

The Options Study believes that, under existing circumstances,
options market makers should have more flexibility in establishing
stock positions to hedge the options risks they assume in carrying
out their market making activities. Generally, an options market
maker will attempt first to hedge his options positions with other
options positions because he has time and place advantage on the
floor of the options exchange in executing options transactions,
and because of his low execution and carrying costs in options.
At times, however, a suitable options hedge may not be practicable
either because of a lack of liquidity in an appropriate put or call
option, particularly an out-of-the-money option, or because the

683

marxet maxer Delieves the premiums on tne appropriate options hedge
exceeds tne costs to mm ot a stocX hedge, or because an appropriate
put option is not listed. Should additional put classes be permitted,
tins need to resort to stocK to nedge options positions may be less.

The Options study oelieves that the credit provisions should
ue revised to ^jermit the options marxet maxer to finance his bona
ride nedging stocx transactions tnrough his clearing firm on a good
laith credit oasis even it the option is out-oi-tne-money. This
ty^e ot tmancing is herein called "Specialist Stock. Credit."

Tne amount ot Specialist StocK Credit available to the options

marxet maxer tnrougn nis clearing tirm must oe carefully defined
to prevent ^jjecialist btocx Creuit trau being used to finance stock
speculation. To accomplish this goal. Specialist Stock Credit should
De strictly limited to tinance no more than the numoer of shares
necessary to otrset tne decrease or increase in the marxet value
ot the nedged options position. In this way, Specialist Stock Credit
will not oe availaoie to tne hiarxet maker to speculate in stocks

underlying listed options oecause any gain on the stock would most
t>rooaoly oe oifset oy an equivalent or greater loss or gain on his
options positions.

To determine wnether a stock position represents a bona fide
nedge ol tne risxs ot an options position, tne ratio of expected
options price movements to underlying stock price cnanges can be
calculated using a ioathematical formula based upon: (1) the current

684

risK tree interest rates (United States yovernjnent securities);
(2) tne exercise price ot the option; (3) the market price of the
stocx; (4) tne time to expiration of the option; and (5) the voiatiiity
ot tne stocK computed trom past stock price movements. This formula
can ue used to predict the numoer of shares of stocK necessary to
onset price movements in related options and is called an "options
pnciny formula". The options Study believes tnat any position in
an underlying stocK obtained or retained in a market maker account
in excess of tnat necessary, as indicated by an options priciny
tormuia, to nedye an options position, or any stock position which
cioes not underlie a qualified options position snould oe immediately
suoject to trie full 5U percent initial maryin requirement and be
buuject to tne same maryin maintenance requirements that apply
to ^udiic customers.

<i. UPiTUNS PRICING FORMULA

Tne amount of premium tor an option is influenced by many factors,
includiny relatively stable factors sucn as interest rates, exercise
price of tiie option, the time to expiration of the option and tne
mstorical volatility of the underlyiny stock. After these more
staoie factors have been considered by the market place, the premium
tor an option becomes directly related to tne price of the underlyiny
stocK. a chanye in the price in the underlyiny stock will normally

685

cause a cnanye in tne price in tne option. The amount of cnange in the

^rice ol tne option compared to tne stock, however, reflects the rela-

tionsnip ot tne stock price to tne exercise price, the probability

ot exercise cased on the historical volatility of tne underlying stock.

and tne time to maturity, because ot a low probability ot exercise ot

a aeep out-ol-tne money option, a small cnange in the price of the stock will

nave little, lr any, ettect on tne options price. A deep in-the-money

option, nowever, will move practically point for point with the stock

since listed options can oe exercised at any time.

Tne greater tne price volatility ot the underlying stock and the
lonyer tne time to expiration, tne greater the cnance that an out-of-the
money option will move into tne money. As time to maturity decreases,
tne iiKelincod of exercise also decreases. Tne opposite is true of
an m-tne-money option. Tne greater the volatility and the longer the
time to expiration ot an in-the-money option, the greater the probability
tnat the option will move out-of-the-money before expiration. But as
time to maturity decreases, tne lixelihood of exercise increases for
an in-tne-noney option.

Tnis relationship of price, volatility, time to expiration and
snort term interest rates can oe mathematically demonstrated by
matnematical formula, sucn as tne Black-Scnoles options pricing mcoel
set lortn in TAbLt; VII-I, wnich determines the actuarial price of an
option yiven tne current stock price, options*' exercise price, stock
volatility, time to expiration and interest rate.

40-940 O - 7 -

686

TABLE VII-I

The Black-Scholes Options Pricing Model

r(t-t*)
w(x,t) = xN(dl) - c e N(d2)

2
d = In x/c + (r+l/2v )(t*-t)

v/t*-t

2
d = In x/c + (r-1/2 v )(t*-t)

v/t*-t

x = current stock price
c = exercise price
v2 = the variance rate of return on the stock
t* = expiration date
t = current time

r = riskfree short-term interest rate
N(d) = the cumulative normal density function
w(x,t) = the option price at time t with stock price x

r(t-t*)
c e = value of discounted riskless bond with a face

value of one that matures on the same date the option
exDires
v = value of the eauity in the hedged position
In = logarithm

N(dl) is also the rate or change in option price with respect to
the change in underlying stock price, and is used as an estimate
of dollar delta.

The model assumes that:

(1) The short-term interest rate is known and is constant.

(2) The distribution of possible stock price is log-normal
and the variance rate of return on the stock is constant,

(3) The stock pays no dividend.

(4) There are no transaction costs.

(5) It is possible to borrow at the short-term interest rate.

(6) There are no restrictions on short selling of securities.

687

The rate of change in the options price in relationship to stock
price can be estimated by using a derivative of the llack-Scholes
Options Pricing Model to provide an estimate of the change in an option's
price given a SI change in the underlying stock price. This estimated
rate of change, the "equivalent share delta/' can be used to estimate
the amount of stock that would theoretically hedge an options position
against small price movements over a brief period of time. For example,
a deep in-the-money near-term option most likely would have a "delta"
of one — meaning a ratio of one for one — and would require a position
of 100 shares of the underlying stock to fully hedge one options contract
exercisable with respect to 100 shares. The equivalent share delta will
never exceed one. On the other hand, an out-of-the-money call would
have a delta of less than one; how much less would depend on the historical
volatility of the underlying stock and time to expiration. If an option
had a delta of .50 then 100 shares of stock would be necessary to hedge
two options exercisable with respect to 200 shares.

The delta hedge formula only predicts small price changes over a
short period of time. It is not designed to predict sudden and large
movements in price during the day. Nevertheless, when sudden and large
price movements do occur a newly-computed delta hedge ratio using the
day's closing prices will automatically take the day's price changes
into consideration to again predict small price movements- for the next
day.

688

The use of an options pricing formula to determine the equivalent
share position that can be financed with Specialist Stock Credit
requires the development by the Commission of a uniform formula
to be used for regulatory purposes. Regulations regarding Specialist
Stock Credit using an equivalent share delta will need to take into
consideration that the equivalent share delta will be computed daily
to reflect, among other factors day-to-day price changes in the
underlying stock and time to expiration, and that the current equivalent
share delta must be communicated to OCC clearing firms and market
makers to permit them to adjust their stock and options positions.

Many options professionals use an equivalent share delta to
adjust their risk positions to reflect the effects of changes resulting
from price movements or other factors. In addition, some OCC members
now perform a delta analysis of the market maker accounts they carry
as a service to the market maker and as a means to assess their risk
exposure as a creditor and guarantor of the market maker positions they
carry. Further, many market makers, as well as upstairs dealers trading
off the floor of the exchange, use an options pricing formula to
determine equivalent share positions in establishing options spread
positions and to determine whether some options are overpriced or under-
priced in relation to the premiums for other options. There are also
independent service bureaus and information processors that provide

689

their users with an options pricing formula. Accordingly, the Options
Study believes that facilities exist for computing and disseminating
a daily equivalent share delta for use by market makers and market
maker clearing firms.

Because the equivalent share delta changes from day-to-day, a market
maker may, without changing his positions, end up with a stock position
that does not qualify for good faith credit, although it was fully qualified
the previous day. To afford the market maker time to adjust his positions,
the Options Study believes that market makers should be permitted to carry
qualified securities in their specialist account in accordance with the
greatest amount permitted as of that day or as of the preceding business
day or such time period as may be demonstrated to the Commission as being
necessary to permit market makers to adjust positions provided that
the market maker only acquired or increased his positions in the
stock in conformance with the equivalent share delta on the day
of the transaction.

If a stock position exceeds the permissible amount that could be
carried on a good faith credit basis due to a change in the equivalent
share delta, the market maker should be permitted to liquidate his excess
positions or adjust his c. tions positions rather than be required to make
a margin deposit. Allowing tne market maker his choice of liquidating
or adjusting positions will give him maximum flexibility in using
his capital in his market making activities.

690

In connection with limiting Specialist Stock Credit to an equivalent
share amount, market maker accounts containing stock and options positions
should be required to show the maximum amount of stock that could be fi-
nanced with Specialist Stock Credit to permit easy review of these
accounts to assure compliance with the rule.

Limiting Specialist Stock Credit to no more than the equivalent share
position required to provide a neutral hedge in an options position will
avoid Specialist Stock Credit being used to finance stock holdings which
are not required to offset risk positions in options obtained in the
course of maintaining a market. With this rule, there would be no reason
to permit market makers to engage in free riding to finance their
stock transactions or to establish a 25 percent margin requirement for
stocks underlying all options listed on an exchange.

Accordingly, the Options Study recommends:

THE COMMISSION SHOULD CONSIDER RECOMMENDING
TO THE FRB THAT THE CLEARING FIRMS FOR MARKET
MAKERS BE PERMITTED TO FINANCE POSITIONS IN
A STOCK UNDERLYING A MARKET MAKER'S OPTIONS
POSITION ON A GOOD FAITH BASIS PROVIDED THE
MARKET MAKER'S SPECIALIST ACCOUNT CONTAINS
ONLY THOSE SHARES NECESSARY TO HEDGE AN OPTIONS
POSITION, AS DETERMINED IN ACCORDANCE WITH
AN APPROPRIATE OPTIONS PRICING FORMULA. 46/

46/ The FRB, however, has taken a different view with respect
to the use of an options pricing formula for this purpose.
See Attachment 7.

691

5. LIMIT ON STOCK QUALIFYING FOR SPECIALIST STOCK CREDIT

All market makers are currently subject to the same credit rules
with respect to stock underlying any class of options listed on the ex-
change where they are registered as a specialist. This permits a market
maker, in effect, to trade in any of these stocks on a more favorable
basis than public customers.

The Options Study recognizes that the competitive market maker
systems were designed to allow flexibility in order to permit competing
market makers to move their activities and capital into different
classes of options as market conditions required. For that reason
the Options Study is not recommending any change in the margin rules
applicable to market makers for options transactions. The Options
Study believes, however, that good faith credit should be restricted to
finance options market maker stock hedge transactions in a limited
number of options classes in which the market maker can be expected
to participate actively.

To recommend a possible limit on the number of stock hedge
positions which should be permitted to be financed with Specialist
Stock Credit without unduly interf erring with the options market,
the Options Study reviewed the accounts of 786 CBOE competitive
market makers for the second quarter of 1978 to determine the extent
to which market makers used stock to hedge options positions. Of
the 786 market makers which held stock positions during the second
quarter of 1978, only 156 held stock positions in more than 20

692

different options classes at one time or another during the period.
Accordingly, the Options Study believes that market makers can be
limited to Specialist Stock Credit for stock underlying no more
than 20 classes of options without unduly interfering with market
making activity, provided Specialist Stock Credit is available to a
market maker called upon by exchange officials to add market making
capacity to an options class when required by short term market
conditions.

Although the Options Study does not believe that limiting
Specialist Stock Credit to stock underlying only 20 options classes
would unduly interfere with the competitive nature of the options
market making systems, this limit should be periodically reviewed
to assure that Specialist Stock Credit is being used properly and
that this limit does not unduly interfere with the market making
process. The market maker should be required to register in those
options in which he expects to be eligible for Specialist Stock
Stock Credit in advance of his obtaining this credit, except in cases
of specific exchange approval.

Accordingly, the Options Study recommends:

THE OPTIONS EXCHANGES SHOULD REVISE THEIR RULES
TO RESTRICT THE ABILITY OF MARKET MAKERS TO
OBTAIN SPECIALIST STOCK CREDIT TO STOCK UNDER-
LYING NO MORE THAN 20 OPTIONS CLASSES, WITHOUT
SPECIFIC EXCHANGE APPROVAL.

693

EXHIBITS TO CHAPTER VII

Exhibit 1

Certain pages of this exhibit have been
deleted from the final Report to conserve
space. This form, in its entirety, is
publicly available through the Cor.nissior ' s
Public Reference Room, 11C0 L Street, ". .,
Washington, D.C.

FOCUO BEPGF.7

form

X-17/1-5

SEC 1695 (7-73) 3/7<

(Financial and Operational Combined Uniform Single Report)

PART II

(Picnic lad msirmtlioHi before preparing I o>

Trs rep."" .sie ■ ■

1) Rule I7a-5(a) j \ 16 ] 2) Rule 17j-5;b; j | 17 |

4) Special request by designated examining authority ( j 19 ]

3) Rule 17a- 1i [ ~ \~il
Other I

NAME OF BROKER-DEALFR

SEC FILE NO.

ADDRLSS OF PR'NCIPAL PLACE OF BUSINESS (Do Hot Use P.O. Box No.)

(No. and Street;

U*L

JjH

Jm]

jjn

FIRM ID. NO.

JL«1

FOR PERIOD BEGINNING (MM/DD/YY

AND ENDING (MM/DD/YY)

NAME AND TELEPHONE NUMBER CF PERSON 10 C0\7ACT IN REGARD TO THIS REPORT (Area Core)— Telephone No.

: . s

NAME(S) OF SUBSIDIARIES OR AFFILIATES CONSOLIDATED IN THIS REPORT:

OFFICIAL USE

::.

DOES RESPONDENT CARRY ITS OWN CUSTOMER ACCOUNTS?
CHECK HERE IF RESPONDENT IS FILING AN AUDITED REPORT

a
o

-^>

EXECUTION:

The registrant/broker or dealer submitting this Form and its attachments and the person(s)
by whom it is executed represent he-eby that ail information contained therein is
correct and complete. It is understood that all required items, statements, and schedules
are considered integral parts of this Form and that the submission of any amendment
represents that a'l unamended items, statements and schedules remain true, correct and
complete as previously submitted.

Manual signatures of-
D

Principal Executive Oiticer or Mpnagmg Partner

Principal Financial O'ficor or Partner

Principal Operations Oldccr or Partner

isslatements or omissions o' lac's const. rule
(fcj te U.S.C. 1001 and 15 U.S.C. 781(a))

694

F0H"1
X-17A-5

SEC 1696 (7-78) 3/76

F0CU3 REPORT

(Financial and Operational Combined Uniform Single Report)

PART HA 0

(Please rciJ instructions before preparing For

This report is being filed pursuan! to (Check Applicable Block(s); ^____

1) Rule 17a-5(a) | j 16 | 2) Rule 17a-5(b) [ | 17 | 3) Rule 17a-11 [ _[ JI8J

4) Special request by designated exnrrin>ng authority j 19~| 5) Other | j 26 |

NAME OF BROKER-DEALER

SEC FILE MO.

ADDRESS OF PRINCIPAL PLACE OF BUSINESS (Do Not Use P.O. Box No.)

S»]

FIRM ID. NO.

FOR PERIOD BEGINNING (MM/DD/YY)

(No. and Street)

AND ENDING (MM/DD/YY)

(City)

NAME AND TELEPHONE NUMBER OF PERSON 10 CONTACT IN REGARD TO THIS REPORT (Area Code)— Telepnone No.
. S B

NAME(S) OF SUBSIDIARIES OR AFFILIATES CONSOLIDATED IN THIS REPORT:

OFFICIAL USE

[in

36
38

37 !

39 :

— . DOES RESPONDENT CARRY ITS OWN CUSTOMER ACCOUNTS? YES | | 40 | NO [~ | 41 |

CHECK HERE IF RESPONDENT IS FILING AN AUDITED REPORT

O
O

o
2:
be:

EXECUTION:

The registrant/broker or dealer submitting this Form and its attachments and the per<;on(s)
by whom it is executed represent hereby that all information contained therein is true,
correct and complete. It is understood that ail required items, statements, and schedules
are considered integral parts ot this Korm and mat the submission of any amendment
represents that all unamended items, statements and schedules remain true, correct and
complete as previously submitted.

Manual signatures ol:
D

Principal Executive Officer or Managing Partner

Principal Financial Officer or Partner

Principal Operations Officer or Partner

ATTENTION -Intentional misstatements or orni',S!0r,s of facts constitute
Federal Criminal Violations. (Sea ie U S.C. 1001 and 15 U.S.C. 78:f(a))

695

Exhibit 2

May 5, 1978

Mr. Wayne P. Luthringshausen

President

The Options Clearing Corporation

5950 Sears Tower

Chicago, Illinois 60606

Dear Mr. Luthringshausen:

In order to assist in our investigation of the standardized
options markets, the Special Study of the Options Markets ("Options
Study") is requesting information, documents, and other data from
you 1/ concerning the operations of the Options Clearing Corporation
COCC" )._2/ While we understand that, in certain instances, part
of the information which ;/e are nov; requesting may have been submitted
previously to other divisions or offices of the Commission, it is
necessary, in order to insure the completeness of the Options Study's
own working files, for you to submit duplicate copies of such documents
to us. In addition, if such previous submissions are not currently
accurate, please amend or update them and continue to inform the
the Options Study staff when further material changes, if any, are
made in the procedures and practices described in your submissions.

We appreciate that our requests may be somewhat detailed and
may require significant effort on the part of the staff of the OCC.
However, to facilitate the progress of the Options Study we ask
your cooperation in this information gathering process, and request
that you transmit the information requested in the enclosed list
not later than May 29, 1978. If, however, responses to certain re-
quests would be materially more complete if based on documentation
being compiled for the OCC's fiscal 1978 (ending June 30, 1978), or

1/ The authority for this request is granted to the Commission

pursuant to Sections 17 and 21 of the Securities Exchange Act of
1934. The Commission is soliciting this information to aid in:
(1) the enforcement of the Securities Exchange Act and the rules
and regulations thereunder; (2) the possible adoption of rules
and regulations under the Securities Exchange Act; and (3)
the establishment of an information base from which the Commission
may recommend further legislation concerning matters to which
the Securities Exchange Act relates.

2/ For purposes of this letter, OCC is meant to include its predecessor
the CBOE Clearing Corporation.

696

Mr. Wayne P. Luthringshausen
Page Two

should any particular request pose undue difficulty or should there
be questions regarding any reqjest, please call Ray J. Grzebielski
at (202) 755-1296 or the undersigned at (202) 755-1285.

The Options Study shares the desire of the self-regulatory
organizations that the activities of the Options Study be completed
in a thorough and timely fashion. Accordingly, while we have requested
that the data and information requested in the enclosed list be
supplied by May 29, 1973, this shared objective would be facilitated
if constituent elements of the attached list are forwarded promptly
to the Options Study before that deadline.

Your cooperation is appreciated.

Sincerely,

Robert L. Smith

Financial Responsibility- and

Credit Specialist

Enclosure

697

Attachment to letter to Wayne P. Luthringshausen
Dated May 5, 1973

Surveillance/Comoliance/Clearina Operations

Please submit the following information to: Special
Study of the Options Markets, Attn: Robert L. Smith,
Securities and Exchange Commission, 500 North Capitol
Street, Washington, D. C. 20549.

In addition, please respond according to the format
provided, and clearly identify in each case the particular
outline item to which your answer is addressed. If particulai
documents submitted pursuant to one item are also germane
to other item(s), it is necessary only to identify such
documents in your answer (s) in relation to such other
item(s). Please type or stamp the name "Options Clearing
Corporation" and the transmittal date of your submission
on each form, brochure, pamphlet or other document submitted
in response to this request.

Please submit your response in duplicate (including
exhibits).

I. Facilities

(A) Annual reoorts. Provide copies of each annual
report issued by the OCC.

(B) Number of people. List the number, names, and
titles of all staff personnel currently employed full-tixr.e
or part-time and their length of service with the OCC.

Also provide employee turnover statistics from the inception
of the OCC. Provide an historical description of the growth
or cutback of the staff and the reasons for any such changes.

(C) Organization. Describe, by means of an
organization chart, if possible, the lines of authority
between and among all personnel.

(D) Supervision. Describe the nature and charac-
ter of the supervision of all of the personnel identified in
Item I.(B) above.

698

(E) Branch offices. List each OCC branch office, its
address, the number of supervisory and clerical employees in
each such office and the functions performed at each office.

(F) Training and experience. Describe each type
of training given to OCC personnel (excluding clerical and
secretarial personnel) and include copies of all materials
used in such training. In addition, describe the educational
levels and relevant prior experience of all supervisory
personnel.

(G) Budget. Provide the internal operating budget
of the OCC, including a budget for each organizational unit,
if available, for fiscal 1977 and the current fiscal year and
the record of the actual expenditures made pursuant to such
budget during 1977. Provide any reports prepared by the
OCC.'s outside auditors with respect to the adequacy or
efficiency of the OCC's internal controls or procedures.

(H) Contracts. List each contract with respect
to the processing or supplying of options-related data to
which the OCC is a party and identify the other party
to the contract by name and address, the services which
the OCC performs or receives, and the fees which the OCC
has paid or received or will pay or receive pursuant to
the contract or any predecessors thereof.

(I) Computer facilities. List all computer facilities
operated or used by the OCC and identify the suppliers thereof
by name and address. Submit summary descriptions of all
software programs used by OCC, together with an indication
of whether such software was developed by the OCC staff
or by an external source. Identify each such external
source by name and address.

(J) Sources of data processing plans and equipment.
Provide copies of any computer manuals or other documents
which describe the operational capabilities of your past,
current or planned computer facilities. State whether your
computer programs have been the subject of a professional
systems analysis, and, if so, provicte the name and current
business address, if known, of the analyst firm and submit
copies of the resulting report.

(K) Agreements. Provide sample copies of alj agreements,
contracts, etc. that OCC users are required by the OCC to execute.

699

(L) Other support services. Describe any other
material support services.

II. Operations

(A) Summary. Provide a summary description of the
clearing and exercise procedures followed by the OCC on

a daily basis. List separately those other procedures employed
periodically or under special circumstances and the frequency
with which they are employed. In this connection, provide
copies of the OCC Operations Manual.

(B) Critical oath charts and documents. Provide a
complete list and sample of each report or document, together
with a brief description of its function, used in connection
with the OCC's options-related processing (whether inputed to
OCC or originated by OCC); state to whom any such documents or
reports are distributed by OCC and the frequency of such
distribution. Provide a flow chart for the OCC's processing
of documents.

for which each is available, relating to standardized options
and the participants in the market for standardized options,
which are maintained and retrievable by or for OCC. Indicate
retention schedules established for such information.

(D) Exercises (rules and applications). Describe
in detail the procedure the OCC uses to effect an exercise
and the manner in which the OCC assigns exercise notices.
Include a description of any modifications in the procedure
since the creation of the OCC. Please provide copies of
all studies conducted by or on behalf of OCC with respect

to assignments of exercises. Describe any special procedures
used in connection with expiration dates.

(E) Adjusted positions. Describe the means by which
clearing members may adjust their positions with OCC and, to the
extent known, the reasons therefor. Also indicate whether,
from the data collected by OCC, the reasons for adjustments

may be determined. State the time limits imposed by the OCC
on clearing firm members for the submission of any adjusted position
reports. State the information provided to other self-regulatory
organizations concerning adjusted positions. Describe any
contemplated changes in the procedures discussed above. For each
month for which an OCC statistical report is submitted pursuant to

700

Item III.(C) which provides data with respect to adjustments,
also provide monthly adjustment figures by type of account for
each clearing firm and totals by type of account.

(F) Inspections. Provide a description of all reports
prepared in connection with any inspections of clearing member

firms made by or on behalf of the OCC prior to admission to membership.
Also describe whether, to what extent, and en what basis the OCC
conducts inspections or audits of clearing member firms after
admission to membership. Provide copies of all agreements between
other self-regulatory organizations and the OCC with respect to
surveillance or compliance inspections. Provide copies of any
check lists or manuals used in such inspections and copies of
the last ten pre-admission and, if applicable, post-admission
inspection reports conducted by OCC as of the date of this letter
(particularly, reports for any such inspections conducted which
included the trading in April, 1978).

(G) Special circumstances studies. Provide copies of
any special studies or contingency planning done by or for the OCC
to meet extraordinary circumstances, disasters, etc.

(H) Suspended trading in an underlying stock. Describe
the criteria which have been and/or will be used to fix the values
of exercised contracts on underlying securities, the trading of which
has been suspended, when either the writer (in the case of a call)
or the holder (in case of a put) does not own such underlying
security. Briefly describe the circumstances of each time, if
any, Article VT, Section 17 of the OCC By-Laws has been invoked.

(I) OCC periodicals. Provide copies of every OCC
Newsletter, OCC Bulletin, member firm educational circulars and
member firm information memoranda.

(J) Operational and financial examination. Provide
copies of the operational and financial examination given to
operational employees of member firms. ;

III. Specific Data Maintained by, or Reported to,
the OCC

(A) Clearing members. Provide a list of all clearing
members from the inception or the OCC until the date of this letter,
listed in the order in which each became a member, and provide
the date each became an OCC member. Identify any such member which
has withdrawn from membership in OCC and describe the circumstances
(failure, voluntary withdrawal from business, merger, etc.)

701

(B) Market information by clearing member. Provide copies
of the monthly clearing memoer ranging report since OCC began
tabulating such report, including the report for April, 1978.

(C) Market information by exchange and bv account type.
Provide copies of the OCC statistical report for each month for
which the OCC has compiled such report, including the report for
April, 1978. Provide any figures OCC may have compiled which
indicate the amount and porportion of monthly cleared trades
(i.e., "records") by type of account and by type of account on
each options exchange.

(D) Transactions in restricted options. State whether
OCC records indicate whetner opening transactions in restricted
options entered for non-spec iaiist-market maker accounts are
covered or spread transactions.

(E) Duration of positions. Please provide any data OCC
may have which indicates average lengths of time that open positions
are held by types of account.

(F) CMTA's, Provide a list of each clearing member firm
which has entered into a clearing member trade assignment authorization,
indicating the options exchange memberships of each party to such
authorizations. Provide a monthly aggregate of volume cleared
through such CMTA's by type of account by options exchange since

the service was initiated.

(G) "As of trades. For each month from July, 1975, to
date, provide the monthly totals of "as of" trades for each exchange.

IV. OCC Margin

(A) Margin report. Provide copies of the OCC margin
report for the trading days of April 12-14, 17-21 and 24, 1978,
summarized by class by clearing firm if possible.

(B) Customer v. market maker account treatment. OCC
Rule 601 requires different treatment of customer and, to the
extent they may exist, firm non-lien accounts than of firm lien
and market makers' accounts. This difference is principally

in the calculation of excess long values and bfee permissible
offset of such long contract values against short contract values.
Provide a concise rationale for this distinction in treatment,
particularly from the point of view of the OCC s risk position.

40-940 O - 79 - 47

702

(C) Margin. Provide, for the end of each calendar
quarter for the years 1973 (beginning with the calendar quarter
ending June, 1973), 1974, 1975, 1976 and 1977, the total margin
required of clearing firms, the total margin deposited and

the types of margin utilized by amount and percentage of the
following:

i. Cash

ii. Government securities

iii. Letters of credit

iv. Escrow receipts

(D) Chances in maroin requirements. Provide a
chronology of any changes in OCC's margin requirements and
brief descriptions of the relevant considerations.

(E) Letters of credit. -"*"

(i) State the number of times, dates and
circumstances that OCC has demanded immediate payment on
the face amount of either a secured or unsecured letter
of credit;

(ii) State the number of times, dates and
circumstances that OCC has not exercised its
right to receive immediate payment on either a
secured or unsecured letter of credit upon obtaining
a written agreement from the issuing bank or trust
company extending such letter of credit providing
a further assurance of the irrevocability of its
commitment;

(iii) Provide representative copies of
letters of credit, both secured and unsecured, from
all issuing banks and trust companies; and

(iv) Provide the names of the banks or trust
companies approved by OCC to issue letters of credit
and the criteria by which the approved banks and
trust companies are selected and any underlying rationales
for such criteria.

703

(F) Escrow receipts.

(i) Provide representative copies of escrow
receipts from all issuing banks and trust companies;

(ii) Provide the names of the banks or trust
companies approved by OCC to issue escrow receipts
and the criteria by which the approved banks and trust
companies are selected and any underlying rationales
for such criteria; and

(iii) State the number of times, date and customers
that OCC has demanded delivery of securities pursuant to
OCC Rule 610(h) which were not delivered by the issuer
of the escrow receipt.

(G) Depository agreements. Provide a sample copy of
a depository agreement for a memoer firm; indicate whether any
material modifications in the stated terms of such sample are
acceptable to, or have been accepted by, OCC and the underlying
rationales for such modifications.

(H) Clearing fund. Provide the total amount in the
clearing fund at the end of each calendar quarter since the
inception of standardized options trading. State whether the
CCC's clearing fund has ever been utilized as indemnity for
a clearing firm member which failed to meet its contractual
obligations to the OCC, and, if so, describe the circumstances.

(I) Early warning notices. Provide a copy of each
early warning notice received by OCC pursuant to OCC rule 303.
State whether OCC is provided with notice of member firms beinq
placed on the special surveillance list of the Securities Investor
Protection Corporation (SIPC Form 5A). If not, would such in-
formation be useful to OCC? Explain.

(J) Variation margin. Explain the criteria used to
determine, under what circumstances, when and for how much, to
issue a variation margin call pursuant to OCC rule 609. Provide
a list of each occasion that variation margin calls have been
made and briefly describe the circumstances, including any failure
by a clearing member to make such calls. State with particularity
the variation margin calls made during the period April 12-14,
17-21 and 24, 1973; what the circumstances were prompting such
calls; and whether any difficulties were encountered either
in the procedures used to make such calls or in member firm
satisfaction of such calls.

704

V. Disciplinary Proceedings

(A) Number of proceedings. Provide, by category (briefly
defining each category), the number of disciplinary proceedings

by the OCC since 1973.

(B) Sanctions. List, by respondent, the violations of
OCC rules for which a fine or other sanction was imoosed since
1973.

(C) Investigative and disciplinary procedures. Describe
generally the procedurdes which the OCC follows to investigate any
potential violations of its rules and the steps taken in formal

or informal proceedings once an apparent violation of the rules is
discovered.

(D) Customer complaints. Submit copies of all customer
complaints or inquiries received by OCC, and describe OCC's
response to each, providing copies of relevant documents.

705

Exhibit 3

June 7, 1*7 -i

At. Will let J. Srocis'-cy
Vic-: President
Trading i .iarxets

African 6tcc* C>:c.iar.no, Ir.c,

06 Trinity i>lace

:*:-* Xcrk, .<e.v x'cr< IG006

Dear .ic. Brodsxy:

In order to concuct its investigation end study cf tne -options
Tiar^Qts, it is necessary tnat tne ipeciai Jtudy or t;ie Options dar^ats
('Options atudy) rosiest cnac you cotain fro.;: your r^ccrus tna
financial oata 2nd ctner inferr-ation cescricea in tne attacasent
to tnis letter relating to your resoers wnicn ace else z*~^j~t3 ot
the Options Clearing Corporation {'CsJL~) cr which conduct a business
solely cr priiaerlly in standardized cotiens anc utilize tne Lacilicic<s
of a clearing nxneer. 1/

While ye understand that, in certain instances, part cf tne
information wnicn we are new requesting <^ay nave U2en sus^itteu
previously to ctner divisions or ctticc-3 oi tne Ccosission* we
woulj appreciate it it you would su^.it duplicate copias or such
docurrents to us in orcer to assure tne cccpieterc-ss cz tne Options
Study's cr~m wording riles. In addition, it sue* c-'revious suxriissiavs
are not airrently accurate, niesse araenu or upoata thers ana continue
to infora tne Options study start woen rurtner cnangeSj if any,
are made in tne procedures ana practices descri-cu in ycur suctfissions.
If niateri3ls recuested uy tnis letter nave oeen previously susaitxau
to tne Options btudy, in a forr: substantially as tnat requested herauy,
it is not necessary to resubmit sucn raterials. aowever, please state
the transmittal cate and tne addressee ol sucn crior submissions.

we appreciate tnat tnis recuest r^ay seek detailed indorsation
which r?ay take ti-re and sioniiicsnt citcrt on tne cart of your stait
to cucpile. However, tne Options stuuy snare3 the nesire or tne

1/ Tne authority for tnis request is aranted to tne demission

pursuant to sections 17 and 21 of tne Securities wxenanoa Act or
1*34. Re Co-T.r.issicn i3 soiicitim tnis imorration to aia in:
(1) tne en£crcer«nt ci tie Securities dxenan^e Act ar.s tiie rules
and regulations tnereunocrs (-) t.-.^ oossioie aooption ot ruies
and cegulccions under tia Securities idxenen^e Act; .<md (3) trie
estaolis «- .r.t ci an inrcr-aatiori sasa trca s*uch the Cosaissicn
asy recc :•: cr-d further legislation ccnccrninj -attc-rs to >vnicn
the :>ecurities Lxcnange .\ct reljtej.

706

Mr. Willie J. aroJsity
Pa^e Two

various self -regulators that the activities ol the Options otuay ce
completer in a tnorcuqn and tinwlv fashion. Accordingly , w.iile we
have requested tnat t-ie data and ir.forrr^ticn requested in toe enclose j
attacrurer.t oe supplied cy July 7, 1)16, tnis shareu objective would
ce facilitated it constituent elements of the attaenrront ace promptly
forwarded to tno Options 3tudy i^iore tnat deadline* ^;igu1j tnere
be ouestions renarcjinq this request, please call tne unuarsignea
at (202) 7:»-1235.

Your cooperation is appreciated.

Sincerely,

Robert L. Sxitli

Financial responsibility and

Credit specialist

Enclosures

707

American Stock Exchange

Attachment to letter to
Dated June 7 , 1978

Please submit the following information to: Special Study
of the Options Markets, Attn: Robert L. Smith, Securities and
Exchange Commission, 500 North Capitol Street, Washington, D.C.
20549.

In addition, we request that you respond according to the
format and on the forms provided, clearly identifying in each
case the particular outline item to which your answer is addressed.
Please type or stamp the name of your exchange and the transmittal
date of your submission on each document submitted in response
to this request.

Please submit your response in duplicate (excluding Forms A
and B).

I. Membership Information

A. Provide a list and the SEC file number, current as
of March 31, 1978, of all members of your organization, which were
also members of the Options Clearing Corporation, and specify

for each such member its designated examining authority pursuant
to 17 CFR 240.17d-l.

B. For each person or organization identified in Item I. A.
above for which your organization is the designated examining authority
pursuant to 17 CFR 240.17d-l, complete Form A.

C. Provide, by clearing member, a list, current as of
March 31, 1978, of all persons or organizations registered as
broker-dealers for which each of those clearing members identified
in Item I.B. above clears options transactions, distinguishing
between those broker-dealers carried in the specialist-market
maker origin with the OCC from those carried in the customer origin.
For each such carried broker -dealer which is carried in the specialist-
market maker origin with OCC, state all its affiliations with
self-regulatory organizations and the capacities in which it

is registered to act with such self-regulatory organizations
including your organization.

708

D. With respect to each joint account trading in options
of which any participant is a registered broker-dealer, carried

by a clearing member identified in Item I.B., identify all participants
in the account (including their SEC file number, if registered as
a broker-dealer) and, to the extent known, any other account in
which such participants maintain an interest, whether with that
clearing member, another member of your organization or otherwise.

E. Provide a list, current as of March 31, 1978, of all persons
or organizations registered as brokers or dealers which conduct a

a business in options on the floor of your exchange noting the
capacity in which such persons or organizations act (e.g., specialist,
market maker, registered option trader, floor broker, independent
board broker, etc.) and whether such persons or organizations lease or
own their memberships. For each person or organization acting in a
dealer capacity on your options exchange and whose account was or
is carried by an OCC member pursuant to 17 CFR 240.15c3-l(a) (6) or
(c)(2)(x) on, or after, December 31, 1975, please complete Form B.

F. Provide the total aggregate equity, total deductions
required by 17 CFR 240.15c3-l and total net equity for all specialist-
market makers in options and registered options traders registered

to do business on your exchange floor as of December 31, 1975,
January 15, and 30, 1976, the end of each calendar quarter of 1976
and 1977, the end of the first calendar quarter of 1978 and for
each of the trading days of April 12-14, 17-21 and 24, 1978.

G. Provide a list of all option specialist-market makers,
registered option traders, floor or board brokers and order book
officials which, since the inception of your standardized options
program, have withdrawn their registration as such, and, to the
extent your files so reflect, provide a brief summary of the
circumstances.

II. Financial Responsibility Monitoring

A. Provide sample copies of all reports that your organization
receives to monitor the financial condition of the OCC members for
which your organization is the designated examining authority pursuant
to 17 CFR 240.17d-l which clear and finance the accounts of options
specialist-market makers and/or registered option traders or brokers,
and state the authority pursuant to which such reports are required
to be filed and the frequency of such reports. If any such designated
OCC clearing members are exempt from such reporting requirements, are
subject to a more frequent reporting cycle, or. are subject to closer
than normal surveillance, state the firm and the reason.

709

B. Provide sample copies of all reports that your
organization receives to monitor the financial condition of option
specialist-market makers, registered option traders, option floor
brokers, board brokers or order book officials registered to act
in such capacity on your exchange. Note the authority pursuant to
which such reports are required to be filed, who files the report
and the frequency of such reports. If any such floor participants
are exempt from any reporting requirements generally applicable
to floor participants operating in a similiar manner or are subject
to a more frequent reporting cycle than generally required, state
the person or firm and the reason.

III. Exchange Revenues

A. Provide, from the inception of standardized options ^)
trading on your exchange, the schedule of all fees and dues
levied by the exchange its affiliations or subsidiaries applicable
to options business. Note each change in any item of such schedule
and the date of such revision. Also state the total amount received
or receivable for each item in such schedule, for each calendar
year in which your exchange has had a standardized options trading
program and for the first calendar quarter of 1978.

B. Provide, from the inception of standardized options
trading on your exchange, for each calendar year, the total expenses
and revenues applicable to such options trading. Break down revenues
by fees, options memberships, provision of communications devices
and sale of market information.

C. Provide for the periods noted in B. above option
related revenue as a percentage of total revenue and net option income
as a percentage of total net income.

IV. Unmatched Trades

A. Provide from the inception of standardized options trading
on your exchange, on a monthly basis, the following average daily
trade comparison system statistics:

1. The total number of (1) contracts, and (2) sides,
entered for comparison;

2. The total number of (1) contracts, and (2) sides,
which remained unmatched after the second trade matching
pass;

710

3. If the final trade matching pass occurs
subsequent to the second trade matching pass, the total
number of (1) contracts, and (2) sides, which remained
unmatched after the final trade matching pass;

4. The total number of (1) contracts, and (2) sides,
which are matched in a matching cycle subsequent to the
final matching pass for the particular days transactions;
and

5. The percentage relationships the statistics
provided under 2, 3, and 4, bear to 1.

Also, provide an explanation of the procedures followed to
match trades that remained unmatched after the second trade matching
pass, and separately, for the final trade matching pass. In addition,
provide separately, the most common reasons why these trades remained
unmatched after the second trade matching pass and the final trade
matching pass. In connection with these explanations describe any
studies that may have been conducted in this regard and any conclusions
that might be drawn therefrom.

B. Describe whether, in computing their compliance with the
provisions of 17 CFR 240.15c3-l(a)(6) and 17 CFR 240.15c3-l(c)(2)(x) ,
OCC members which carry broker-dealer accounts in the market maker
origin with the OCC, included in I.B. , determine their requirements
pursuant to the above sections on the basis of trades entered into
the clearance system by such specialist-market makers and registered
traders or on the basis of trades which have been matched by the
second pass on the day on which the trade was executed.

C. If the clearing firms requirements are determined
by trades entered, provide a description of each clearing
member's procedures for adjusting an account for trades that
remain unmatched by the final pass. Additionally, if such adjust-
ments would have increased the clearing firm's charges to net
worth or a specialist-market maker's or registered trader's equity
requirement, as of the day on which the trade was entered, what

is the clearing member's procedure or policy for reflecting such
additional deduction in its net capital computation and for obtaining
such additional deposits.

D. Provide a list of your organization's rules, and a
summary of each that govern the above procedures.

711

V. Commencement of Trading

Provide the date that actual trading commenced in each option
class which has been approved for trading on your exchange. Provide
the date on which an option class trading on your exchange was withdrawn
from trading, and briefly describe the reasons why.

VI. Special Studies

Provide a copy or describe the results of any special study
or surveillance program undertaken by your organization with regard
to the impact, both operational or financial, of the April 14-21,
1978 volume and price increases. If you have initiated such a study
or program which has not been completed, please provide a description
of your undertaking and its anticipated completion date.

712

June 7, 19? S

:5C. JarneS £. Qowd

President

Boston Stcc< £xcnanue, inc.

53 ^tate Street

Boston, .ias sachuse tts G21U9

Dear iir. Dcwd:

In order tc conduct its investigation arj study of tne cction-3
rrarkets, it is necessary tnet tne Special Study of tne Motions siscketa
( 'Cot ions Study) request tn-nt you Obtain ^'rorr, your records the
finevneiai data and etner inncrr-ation oescnujd in tie artaenr.^ent
to tnis letter relating to your rrerccro whieni are also reisers of
tne Options Clear ing Corporation {~OCZ") or which conduct a business
solely cr ->ti.?arily in standardized options and utilize the facilities
of a clesring pe^cer. 1/

While we understand that, in certain instances, cart of the
information wnicn we are now requesting r.ay have o«en suoaitteu
previously to ct^er divisions or offices cr tae Corliss ion, we
would appreciate it it you would submit ouolicate copies of sucn
docunsnt3 to us in ordsr to assure tne cor.nieteness cr the Options
Study's own worKinj files. In addition, it sucn previous suGOissions
are not currently accurate, please anend or update thea and continue
to infers tne Gotion3 Study staff vnen furtner cuanqes, it any,
are rr\ace in the procedures and practices described in your submissions,
If materials requested by this letter nave oeen previously suu:iitted
to tne Options Study, in a form substantially as that requested herccv,
it is not necessary to resuo^it sucn materials, however, please scate
tile transmittal uate and the addressee or such prior submissions,

Vfe appreciate tnat tnis request rsay 3ee* detailed information
wnicn nay tai;e ti.ne and significant effort on the part of your staff
to compile. Hov«ver, tne options stuay snares tae desire of tze

1/ The authority for tnis rosiest is granted to tne Ca:T?.issicn

pursuant to sections 17 and 21 of tne Securities bxcnanqe Act of
1934. Tne Conmssicn is soliciting tnis information to aid in:
(1) tne enforcement of tne securities wxcnanqe Act and the rules
and regulations tnercunoc-rj (2) the oossiole aoootion of ruies
*p,.4. regulations uruter tr.31 Securities ^xchanqe .^ct; ar.u (3) the
estaoiish.vint of an inicr:'*3tion base rroa wnicn tne Commission
flicy reccnriiend rurtner legislation concerning setters* to wnicn
tne Securities sxcnr.nqe Act relates.

713

rtr. J arcs L. Dovd

various selii-re-ulators tnat tr.e activities o£ trie jrtions Study iLe
car^leted in a tnoroucjn ana ti.Tely tasmcn. Accordingly, wnile wv?
have requested tnat tne cata and indentation requested in tne enclosed
attachment oe sucplied cy July 7, lwtf, tais snared cojective would
be facilitate; ll constituent elo?nts or tne attacnaent arc prcr-atly
forwarded to tne Orrticns dtu'jy ceiore tnat aeaulina. Jnculd tr.ere
be cuestions rooardim tnis reauest, oiease call the under si^nad
at (202) ?3>1235.

four cooperation is asjyreciatea.

Sincerely,

Robert L. dmitn

Financial ^esoensioiiity and

Creait Specialist

Enclosures

714

Boston Stock Exchange

Attachment to letter
Dated June 7, 1978

Please submit the following information to: Special Study
of the Options Markets, Attn: Robert L. Smith, Securities and
Exchange Commission, 500 North Capitol Street, Washington, D.C.
20549.

Please submit your response in duplicate (excluding Forms A
and B).

I. Membership Information

A. Provide a list and the SEC file number, current as

of March 31, 1978, of all members of your organization, which were
also members of the Options Clearing Corporation, and specify
for each such member its designated examining authority pursuant
to 17 CFR 240.17d-l.

B. For each person or organization identified in Item I. A.
above for which your organization is the designated examining authority
pursuant to 17 CFR 240.17d-l, complete Form A.

C. Provide, by clearing member, a list, current as of
March 31, 1978, of all persons or organizations registered as
broker-dealers for which each of those clearing members identified
in Item I.B. above clears options transactions, distinguishing
between those broker -dealers carried in the specialist-market
maker origin with the OCC from those carried in the customer origin.
For each sucn carried broker-dealer which is carried in the specialist-
market maker origin with OCC, state all its affiliations with
self-regulatory organizations and the capacities in which it

is registered to act with such self-regulatory organizations
including your organization.

715

D. With respect to each joint account trading in options
of which any participant is a registered broker-dealer, carried
by a clearing memoer identified in Item I.B., identify all participants
in the account (including their SEC file number, if registered as
a broker-dealer) and, to the extent known, any otner account in
which such participants maintain an interest, whether with that
clearing member, another memoer of your organization or otherwise.

II. Financial Responsibility Monitoring

Provide sample copies of all reports that your organization
receives to monitor the financial condition of the OOC memoers for
which your organization is the designated examining authority pursuant
to 17 CFR 240.17d-l which clear and finance the accounts of options
specialist-market makers and/ or registered option traders or brokers,
and state the authority pursuant to which sucn reports are required
to be filed and the frequency of such reports. If any such designated
OCC clearing members are exempt from such reporting requirements, are
subject to a more frequent reporting cycle, or are subject to closer
than normal surveillance, state the firm and the reason.

III. Unmatched Trades

A. Describe whether, in computing their compliance with the
provisions of 17 CFR 240.15c3-l(a) (6) and 17 CFR 240.15c3-l(c) (2)(x) ,
OCC members which carry broker-dealer accounts in the market maker
origin with the OCC, included in I.B. , determine their requirements
pursuant to the above sections on the basis of trades entered into
the clearance system by such specialist-market makers and registered
traders or on the basis of trades whicn have been matched by the
second pass on the day on which the trade was executed.

B. If the clearing firms requirements are determined
by trades entered, provide a description of each clearing
member's procedures for adjusting an account for trades that
remain unmatched by the final pass. Additionally, if such adjust-
ments would have increased the clearing firm's charges to net
worth Or a specialist-market maker's or registered trader's equity
requirement, as of the day on which the trade was entered, what

is the clearing member's procedure or policy for reflecting such
additional deduction in its net capital computation and for obtaining
such additional deposits.

C. Provide a list of your organization's rules, and a
summary of each that govern the above procedures.

716

IV. Special Studies

717

June 7, lii'/d

dr. Bruce J. Simpson

Executive vice President

Chicago t-;o?ra Options Lxcnsr.oe, inc.

LaSalle at JdcKson

Cnicago, Illinois 60604

Dear Mr. S tots on:-

In order to conduct its investigation ana study of the options
markets, it is necessary tnat the special Stuoy of tne Options r.ar<ci:s
("'jptions stusy) request that you cotain Lroa your records trie
financial Jata and ether information aescrisea in the attachment
to this letter relating to ycur nsercers tvnic.n are also teasers of
the Options Clearing Corporation ("OOC") or wnich conduct a business
solely or primarily in standardize options and utilize tne iacint::-s
of a clearing ;remoer. 1/

While we understand that, in certain instances, part of the
information wnicn vo are now requesting ssy have ceen submitted
previously to otner divisions or ofiices of the Ccrcsission, we
would ac^reciate it if you would suauit Duplicate copies of such
documents to u3 in order to assure tne completeness of tne Options
Study's own '.forking files. In acaition, if such previous suuaissions
are not currently accurate, rslease amenu or update ti>era ana continue
to inform tne Options Stuay staff when lurtner changes, if any,
are maoe in Lie procedures and practices ucscriscd in ycur submissions.
If materials requested oy this letter have oeen creviously 3u£niitteu
to the Options Study, in a fcr:c substantially as tnat reouested hereoy,
it is not necessarv to resubmit such ^materials. However, please state
the transmittal uate ana the sdaresse-e or suai prior submissions.

we anoreciate tnat this reouest may see* detailed information
whicn rr.ay take tire ana significant effort on tne part of ycur staff
to compile. However, tne options Study snares tne desire of tne

1/ Tne autnority for this request is granted to the Coasaissicn

pursuant to Sections 17 anu 21 of tne jecurities exchange Act of
li*34. 2he Cortnission is soliciting tiiis information to aic in:
(1) the enforcement of tne Securities Exc'iange Act and the rules
and regulations tnereunder; (2) the possible aoo£tion of rules
and regulations unuer tne Securities Exchange Act} 'ana* (3) tne
establishment ot an intor.T-aticn ocse troni Alien tne cewnaission
say reccis^end further legislation concerning n&tcera to wnicu
the Securities Sxcaange Act relates.

40-940 O - 79 - 48

718

.^.r. 3ruce J. Simpson
Page Two

various seli-regulators that the activities c£ the Options Study oe
couple tea in a thorouqn and ti.nely las.iicn. Accordingly , wnile we
have rcouest'rc tnat tie oata arid ir.iorrr.aticn requested in tne enclosed
attacn.7«nc ce supolieo Dy July 7, ly/S, tais shared oo^octive woulo
be facilitated it constituent elements or tne attacfoicnt ace prcnptiy
tcrwarcea to tne Options Study betore tnat oea.jline. Snoula there
be ^esticns regaruing thi3 request, please call tne unosrsignea
at (2u2) 755-12S5.

Your cooperation is appreciated.

Sincerely,

Robert L. Smith

financial Responsibility and

Creait Specialist

Enclosures

719

Chicago Board Options Exchange

Attachment to letter to
Dated June 7 , 1978

Please submit the following information to: Special Study
of the Options Markets, Attn: Robert L. Smith, Securities and
Exchange Commission, 500 North Capitol Street, Washington, D.C.
20549.

Please submit your response in duplicate (excluding Forms A
and B).

I. Membership Information

A. Provide a list and the SEC file number, current as

B. For each person or organization identified in Item I. A.
above for which your organization is the designated examining authority
pursuant to 17 CFR 240.17d-l, complete Form A.

C. Provide, by clearing member, a list, current as of
March 31, 1978, of all persons or organizations registered as
broker -dealers for which each of those clearing members identified
in Item I.B. above clears options transactions, distinguishing
between those broker -dealers carried in the specialist-market
maker origin with the OCC from those carried in the customer origin.
For each such carried broker-dealer which is carried in the specialist-
market maker origin with OCC, state all its affiliations with
self-regulatory organizations and the capacities in which it

is registered to act with such self-regulatory organizations
including your organization.

720

D. With respect to each joint account trading in options
of which any participant is a registered broker-dealer, carried

by a clearing member identified in Item I.B. , identify all participants
in the account (including their SEC file number, if registered as
a broker-dealer) and, to the extent known, any other account in
which such participants maintain an interest, whether with that
clearing member, another member of your organization or otherwise.

E. Provide a list, current as of March 31, 1978, of all persons
or organizations registered as brokers or dealers which conduct a

a business in options on the floor of your exchange noting the
capacity in which such persons or organizations act (e.g. , specialist,
market maker, registered option trader, floor broker, independent
board broker, etc.) and whether such persons or organizations lease or
own their memberships. For each person or organization acting in a
dealer capacity on your options exchange and whose account was or
is carried by an OCC meTiber pursuant to 17 CFR 240.15c3-l(a)(6) or
(c)(2) (x) on, or after, December 31, 1975, please complete Form B.

F. Provide the total aggregate equity, total deductions
required by 17 CFR 240.15c3-l and total net equity for all specialist-
market makers in options and registered options traders registered

II. Financial Responsibility Monitoring

A. Provide sample copies of all reports that your organization
receives to monitor the financial condition of the OCC members for
which your organization is the designated examining authority pursuant
to 17 CFR 240.17d-l which clear and finance the accounts of options
specialist-market makers and/or registered option traders or brokers,
and state the authority pursuant to which such reports are required
to be filed and the frequency of such reports. If any such designated
OCC clearing members are exempt from such reporting requirements, are
subject to a more frequent reporting cycle, or are subject to closer
than normal surveillance, state the firm and the reason.

721

III. Exchange Revenues

A. Provide, from the inception of standardized options
trading on your exchange, the schedule of all fees ana dues
levied by the exchange its affiliations or subsidiaries applicable
to options business. Note each change in any item of such schedule
and the date of such revision. Also state the total amount received
or receivable for each item in such schedule, for each calendar
year in which your exchange has had a standardized options trading
program and for the first calendar quarter of 1978.

C. Provide for the periods noted in B. above option
related revenue as a percentage of total revenue and net option income
as a percentage of total net income.

IV. Dnmatched Trades

A. Provide . ora the inception of standardized options trading
on your exchange, on a ..onthly basis, the following average daily
trade comparison system statistics:

1. The total number of (1) contracts, and (2) sides,
entered for comparison;

2. The total number of (1) contracts, and (2) sides,
which remained unmatched after the second trade matching
pass; "•

722

4. The total number of (1) contracts, and (2) sides,
which are matched in a matching cycle subsequent to the
final matching pass for the particular days transactions;
and

5. The percentage relationships the statistics
provided under 2, 3, and 4, bear to 1.

B. Describe whether, in computing their compliance with the
provisions of 17 CFR 240.15c3-l(a)(6) and 17 CFR 240.15c3-l(c) (2) (x) ,
OCC members which carry broker-dealer accounts in the market maker
origin with the OCC, included in I.B., determine their requirements
pursuant to the above sections on the basis of trades entered into
the clearance system by such specialist -market makers and registered
traders or on the basis of trades which have been matched by the
second pass on the day on which the trade was executed.

is the clearing member's procedure or policy for reflecting such
additional deduction in its net capital computation and for obtaining
such additional deposits.

D. Provide a list of your organization's rules, and a
summary of each that govern the above procedures.

723

V. Commencement of Trading

VI. Special Studies

724

June 7, liJ'/J

Mr. Kenneth I. fccscnbluai
Scnicr Vice president *

General Counsel
• liuv.es t UtocK txcnsnqe, Inc.
12J South Laiallo Street
Chicago, Iilinoi3 6o6\J3

Dear Mr. Hosenhla-Dr

In order to cor.suct its investigation and study of tne options
markets, it i3 necessary tnat tne Special Study of the Options i'larKets
('Got ions Study-) recuest that you obtain from your recoras the
financial data and otner irfor.ration described in tec attseusent
to tins latter relating to your :rocbers wmen are also menoers of
the Options Clearing Corporation ('OCC-*) or wmen cenuuet a business
solely or ^tLrarily in standardized options end utilize the facilities
of a clearing senscr. i/

While we understand that, in certain instances, pc.rt of the
information whica *ve are now requesting nay nave been submitted
previously to other, divisions or offices oi tne Cottsission, we
would appreciate it if you would submit duplicate ccoies of sucn
doc'jmar.ts to U3 in order to assure the completeness or tne Options
Study's cwn worKin-j Jtilcs, In addition, li sucn previous submissions
are net currently accurate, please amend or upuste them and continue
to inters, tne Options Study stair when further changes, if any,
are made in the proceaures and practices coscricoa in /our submissions.
If materials requested by this letter have iX;en previously suomittes
to tne Options study, in a form sucstantisiiy as tnat revested nereuy,
it is not necessary to resubmit sucn materials. However, please state
the transmittal date and the adoressee of sucn prior submissions.

We appreciate that this recuest nay seek detailed information
which 7nay tafce time and significant effort on the e-srt of your staff
to compile. However, tne Options Study snares the ce^ire of tne

1/ The authority for this request is granted to the Oxmission

pursuant to Sections 1? ana 21 of tne Securities Lxcnsnge Act of
li)34. Tne Ccsuiission is soliciting this information to aid in:
(1) the enforcement of tno Securities t:xcnance Act and the rules
and regulations thereunder; (2) the rcssiole aucetion of rulc3
and regulations unoer tne Securities ^xenanqe Act; ana (3) tne
establishment ol an incarnation case from which tne Co.mmi33icn
may recommend iurtner legislation concerning matters to wnicn
the securities Lxc.ianqe Act relates.

725

Mr. ttenr.etfl I. r-o3onclu.:
Page r.;o

various nelf-renuictors that the activities or tnc» Options otudy L;o
carpleLcu in a tnorcugn anJ tireiy fashion. Accordingly, while we
nave requested kiat tne cata an-J information recjuestea in tne enclosed
attacninent ce supplied oy July /, l>7-3, tnu soared oojective would
be Laciiitab-xi ii corGtituent elements or the attacnsent are promptly
forwarcoi to the Qotions Stucy c^rore tnat deadline. Snoulu tr.cre
be questions reiiarair.-g this request* please call tne ur/ucrsigneo
at (2U2) 7i5-12:Jo.

i'our cooperation is appreciated.

Sincerely,

Robert L. Smith

Financial *e3ponsiDility ana

Credit Specialist

Enclosures

726

Midwest Stock Exchange

Attachment to letter to
Dated June 7, 1978

Please submit the following information to: Special Study
of the Options Markets, Attn: Robert L. Smith, Securities and
Exchange Commission, 500 North Capitol Street, Washington, D.C.
20549.

Please submit your response in duplicate (excluding Forms A
and B).

I. Membership Information

A. Provide a list and the SEC file number, current as

B. For each person or organization identified in Item I. A.
above for which your organization is the designated examining authority
pursuant to 17 CFR 240.17d-l, complete Form A.

C. Provide, by clearing member, a list, current as of
March 31, 1978, of all persons or organizations registered as
broker -dealers for which each of those clearing members identified
in Item I.B. above clears options transactions, distinguishing
between those broker -dealers carried in the specialist -market
maker origin with the OCC from those carried in the customer origin.
For each such carried broker -dealer which is carried in the specialist-
market maker origin with OCC, state all its affiliations with

self -regulatory organizations and the capacities in which it
is registered to act with such self -regulatory organizations
including your organization.

727

D. With respect to each joint account trading in options
of which any participant is a registered broker-dealer, carried

E. Provide a list, current as of March 31, 1978, of all persons
or organizations registered as brokers or dealers which conduct a

a business in options on the floor of your exchange noting the
capacity in which such persons or organizations act (e.g. , specialist,
market maker, registered option trader, floor broker, independent
board broker, etc.) and whether such persons or organizations lease or
own their memberships. For each person or organization acting in a
dealer capacity on your options exchange and whose account was or
is carried by an OCC member pursuant to 17 CFR 240.15c3-l(a) (6) or
(c)(2) (x) on, or after, December 31, 1975, please complete Form B.

F. Provide the total aggregate equity, total deductions
required by 17 CFR 240.15c3-l and total net equity for all specialist-
market makers in options and registered options traders registered

G. Provide a list of all option specialist-market maxers,
registered option traders, floor or board brokers and order book
officials which, since the inception of your standardized options
program, have withdrawn their registration as such, and, to the
extent your files so reflect, provide a brief summary of the
circumstances.

II. Financial Responsibility Monitoring

A. Provide sample copies of all reports .that your organization
receives to monitor the financial condition of the OCC members for
which your organization is the designated examining authority pursuant
to 17 CFR 240.17d-l which clear and finance the accounts of options
specialist-market makers and/or registered option traders or brokers,
and state the authority pursuant to which such reports are required
to be filed and the frequency of such reports. If any such designated
OCC clearing members are exempt from such reporting requirements, are
subject to a more frequent reporting cycle, or are subject to closer
than normal surveillance, state the firm and the reason.

728

B. Provide sample copies of all reports that your
organization receives to monitor the financial condition of option
specialist-market makers, registered option traders, option floor
brokers, board brokers or order book officials registered to act
in such capacity on your exchange. Note the authority pursuant to
which such reports are required to be filed, who files the report
and the frequency of such reports.. If any such floor participants
are exempt from any reporting requirements generally applicable
to floor participants operating in a similiar manner or are subject
to a more frequent reporting cycle than generally required, state
the person or firm and the reason.

III. Exchange Revenues

A. Provide, from the inception of standardized options
trading on your exchange, the schedule of all fees and dues
levied by the exchange its affiliations or subsidiaries applicable
to options business. Note each change in any item of such schedule
and the date of such revision. Also state the total amount received
or receivable for each item in such schedule, for each calendar
year in which your exchange has had a standardized options trading
program and for the first calendar quarter of 1978.

C. Provide for the periods noted in B. above option
related revenue as a percentage of total revenue and net option income
as a percentage of total net income,

IV, Unmatched Trades

A. Provide from the inception of standardized options trading
on your exchange, on a monthly basis, the following average daily
trade comparison system statistics:

1. The total number of (1) contracts, and (2) sides,
entered for comparison;

2. The total number of (1) contracts, and (2) sides,
which remained unmatched after the second trade matching
pass;

729

4. The total number of (1) contracts, and (2) sides,
which are matched in a matching cycle subsequent to the
final matching pass for the particular days transactions;
and

5. The percentage relationships the statistics
provided under 2, 3, and 4, bear to 1.

Also, provide an explanation of the procedures followed to
match trades that remained unmatched after the second trade matching
pass, and separately, for the final trade matching pass. In addition,
provide separately, the roost common reasons why these trades remained
unmatched after the second trade matching pass and the final trade
matching pass. In connection with these explanations describe any
studies that may have been conducted in this regard and any conclusions
that might be drawn therefrom.

B. Describe whether, in computing their compliance with the
provisions of 17 CFR 240.15c3-l(a)(6) and 17 CFR 240.15c3-l(c) (2) (x) ,
OCC members which carry broker-dealer accounts in the market maker
origin with the OCC, included in I.B., determine their requirements
pursuant to the above sections on the basis of trades entered into
the clearance system by such specialist -market makers and registered
traders or on the basis of trades which have been matched by the
second pass on the day on which the trade was executed.

is the clearing member's procedure or policy for reflecting such
additional deduction in its net capital computation and for obtaining
such additional deposits.

D. Provide a list of your organization's rules, and a
summary of each that govern the above procedures.

730

V. Commencement of Trading

VT. Special Studies

731

June 7, 11)73

rlr. John T. »all

Senior vice President

Corpliance Division

National Association of securities

Dealers, Inc.
1735 K Street, N.W.
Washington, D.C.

Dear fir. Wall:

In order to conduct its investigation and study of the options
markets, it is necessary tnat tne Special Study of the Options ..arKets
("Options Study-) request tint you obtain crew your reccros the
financial data and otner inform t ion cescriceu in the attachment
to this letter relating to your aaasers whicn are slco members cf
tne Options Clearing Corporation ("GGC") or wnicn conduct a ousmess
solely or pricariiy in standardized options and utilize tne facilities
of a clearing nemoer. 1/

while we understand that, in certain instances, part of tne
information whicn we are now requesting may nave cesn suonitted
previously to other civisiens or offices cf tne Con;?, is s ion, wc
would appreciate it if you would sutar-it duplicate copies of sucn
documents to us in orasr to assure tne completeness or tne Options
Study's own working files. In acaition, ir sucn previous suzxnissions
are not currently accurate, please amend or update tnem ana continue
to inform tne Options Stuay staff when fur tne r changes, ir any,
are made in the procedures anu oractices cescrioed in your submissions.
If materials recuestea oy tnis letter have rieen previously suanitteo
to tne Oct ions Studv, in a form substantially as that recruestea hsrsoy,
it is not necessary to resumit sucn mate-rials, iiowever, please state
the transmittal date and tne acoressee cf sucn prior cuanissiens .

We appreciate that this request may seek detailed information
whicn may take time and significant effort en the part of your staff
to compile, riowever, the Options study snares tne uesire of the

1/ The authority for tnis recuest is granted to tne Commission

oursuant to Sections 17 and 21 cf the Securities exchange Act oi
1934. Tne Commission i3 soliciting tnis information to aid in:
(1) the enforcement cf tne ^.ecuritic^ ^xenange Act and tne ruias
and regulations tnereunuerj (2) tne possiole adoption of rules
and regulations unuer tne securities -.xenange Act; and (3) the
estaolisnincnt of an inrcr ration base.irom wnicn tne Commission
may recoraend fnrtner legislation concerning ratters to wnicn
the securities wxenanoe Act relates.

732

Mr. John T. wall
Page lV/o

various self-regulators tnat the activities oi tne Options Study be
completer in a tncrcttgn and ti.rely lasnion. .accordingly, wnile we
have requested tiiat the data ana information requester in tne enclosed
attacn^cnt ae suopliad by July 7, liT/tf, this snareu conceive would
be facilitated if constituent elements ot tne attacn-ent ace prosody
forwarcej to tne Options Study osicre tnat ccaoline. Sncula tnere
be questions regarding this recuest, please call the uncersigneo
at (2Q2) 755-1265.

Your cooperation is appreciated.

Sincerely,

Robert L. Smith

financial Responsibility and
Credit Specialist

Enclosures

733

National Association qf^) . «' ~)

Securities Dealers ^

Attachment to letter
Dated June 7, 1978

Please submit the following information to: Special Study
of the Options Markets, Attn: Robert L. Smith, Securities and
Exchange Commission, 500 North Capitol Street, Washington, D.C.
20549.

Please submit your response in duplicate (excluding forms A
and B) .

I. Membership Information

A. Provide a list and the SEC file number, current as

B. For each person or organization identified in Item I. A.
above for which your organization is the designated examining authority
pursuant to 17 CFR 240.17d-l, complete Form A.

C. Provide, by clearing member, a list, current as of
March 31, 1978, of all persons or organizations registered as
broker-dealers for which each of those clearing members identified
in Item I.B. above clears options transactions, distinguishing
between those broker-dealers carried in the specialist-market
maker origin with the OCC from those carried in the customer origin.
For each sucn carried broker-dealer which is carried in the specialist-
market maker origin with OCC, state all its affiliations with
self-regulatory organizations and the capacities in which it

is registered to act with such self-regulatory organizations
including your organization.

40-940 O - 79 - 49

734

D. With respect to each joint account trading in options
of which any participant is a registered broker -dealer , carried
by a clearing memoer identified in Item I.B., identify all participants
in the account (including their SEC file number, if registered as
a broker-dealer) and, to the extent known, any other account in
which such participants maintain an interest, whether with that
clearing member, another memoer of your organization or otherwise.

II. Financial Responsibility Monitoring

Provide sample copies of all reports that your organization
receives to monitor the financial condition of the OCC members for
which your organization is the designated examining authority pursuant
to 17 CFR 240.17d-l which clear and finance the accounts of options
specialist-market makers and/or registered option traders or brokers,
and state the authority pursuant to which such reports are required
to be filed and the frequency of such reports. If any such designated
OCC clearing members are exempt from such reporting requirements, are
subject to a more frequent reporting cycle, or are subject to closer
than normal surveillance, state the firm and the reason.

III. Unmatched Trades

A. Describe whether, in computing their compliance with the
provisions of 17 CFR 240.15c3-l(a) (6) and 17 CFR 240.15c3-l(c) (2)(x)r
OCC members which carry broker-dealer accounts in the market maker
origin with the OCC, included in I.B. , determine their requirements
pursuant to the above sections on the basis of trades entered into
the clearance system by such specialist-market makers and registered
traders or on the basis of trades which have been matched by the
second pass on the day on which the trade was executed.

B. If the clearing firms requirements are determined
by trades entered, provide a description of each clearing
member's procedures for adjusting an account for trades that
remain unmatched by the final pass. Additionally, if such adjust-
ments would have increased the clearing firm's charges to net
worth Or a specialist-market maker's or registered- trader's equity
requirement, as of the day on which the trade was entered, what

is the clearing member's procedure or policy for reflecting such
additional deduction in its net capital computation and for obtaining
such additional deposits.

C. Provide a list of your organization's rules, and a
summary of each that govern the above procedures.

735

IV. Special Studies

736

June 7, !*/■■

;->r. Jcnn J. SenKcwici
Assistant tfice Presicent
Now ior:^ Stocx lixchan-ge, Inc.
:ew York, iww i'orfc 1jG41

Dear dr. 3en<ewich:

In crc'er to conduct its investigation and study of tiia options
markets, it is necessary that tno Special Study ci tne Options liarfcets
("Options study) request that you obtain irem your records tne
financial cats and otner information described in the attacn-ont
to tiiis letter relating to your rt&aoers wnich are also ir.stfoers oi
the Qoticns Clearing Corporation ("OCC") or union conouct a ousmess
solely cr primarily in starkinrGiseu options ana utilize taa facilities
of a clear m-j aesoec. 1/

While we understand that, in certain instances, part of tne
information which we are now requesting may nave oeen suonitteci
previously to ether divisions or offices of the CCiKaission, we
would appreciate it if you would sumit duplicate copies or suca
docuifient3 to us in order to assure the completeness cr t*\e Options
Study's own working files. In addition, if sucn previous su«aissicn3
are not currently accurate, please a.rend or update tnea and continue
to inform the -Options Study staff when further caangeg, it any,
are tnaue in the orccedures and practices aescrised in your submissions,
If materials requested ay this letter have i^een previously suasittsu
to the Options study, in a form suostantially cs that requested nereuy,
it is not necessary to resucaut sucn materials, however, please stoce
tne transmittal oate arc the addressee of such pricr sun?, is s ions.

we appreciate that this request nay seei; detailed information
which ;nay tsKe tine ana significant effort on tne part cr your stair
to compile. However, tne Options atuay snares trie" desire or tne

1/ The authority cor tnis request is granted to the Cc~~iission

pursuant to Sections 17 anci 21 or the Securities bxenange Act of
1^34. lae Casr.ission is soliciting tnis intor.Taticn to aia in:
(1) the enforcement of tne securities exchange Act and tne rules
and regulations tnercuncer; {*.) tne possible adoption cf rules
and re-iulacior.s unuer tue securities Excnan-je \ctr aas (3) tne
estoblisi^cnt or on inr or/ration case iro.:» wnica the commission
nay recorxrsnd further legislation concerning .*Qatt£.rs*to vnicn
tne securities Lxcnange Act relates.

737

Hz. John J. Sen*e*ich
Page Two

various self-regulators tnat the activities ot the Options Study ce
car.Dleted in a thorough ana tir.oly casnicn. Accordingly, wnile we
nave ceauestou that tne data and mi or nation requested in tns encloses
at tacrine be supplied by July 7, l:>/6, tins snared CDjective would
be facilitated if constituent elements or tne attacnasnt are prcsotiy
forvaroed to tne actions otucy ociorc that cecialine. ^,-ioula tnero
be cuestions reoaroing triis reouest, please call the undersigned
at (202) 735-12od.

Your cooperation i3 appreciated.

sincerely,

Robert L. 6~ith

financial Recoonsibility and

Credit Specialist

Enclosures

738

'New York Stock Exchange";

Attachment to letter
Dated June 7, 1978

Please submit the following information to: Special Study
of the Options Markets, Attn: Robert L. Smith, Securities and
Exchange Commission, 500 North Capitol Street, Washington, D.C.
20549.

Please submit your response in duplicate (excluding forms A
and B).

I. Membership Information

A. Provide a list and the SEC file number, current as

B. For each person or organization identified in Item I. A.
above for which your organization is the designated examining authority
pursuant to 17 CFR 240.17d-l, complete Form A.

C. Provide, by clearing member, a list, current as of
March 31, 1978, of all persons or organizations registered as
broker -dealers for which each of those clearing members identified
in Item I.B. above clears options transactions, distinguishing
between those broker -dealers carried in the specialist-market
maker origin with the OCC from those carried in the customer origin.
For each sucn carried broker-dealer which is carried in the specialist-
market maker origin with OCC, state all its affiliations with

self -regulatory organizations and the capacities in which it
is registered to act with such self-regulatory organizations
including your organization.

739

D. With respect to each joint account trading in options
of which any participant is a registered broker-dealer, carried
by a clearing memoer identified in Item I.B., identify all participants
in the account (including their SEC file number, if registered as
a broker-dealer) and, to the extent known, any other account in
which such participants maintain an interest, whether with that
clearing member, another memoer of your organization or otherwise.

II. Financial Responsibility Monitoring

III. Unmatched Trades

A. Descrioe whether, in computing their compliance with the
provisions of 17 CFR 240.15c3-l(a) (6) and 17 CFR 240.15c3-l(c) (2)(x) ,
OCC members which carry broker-dealer accounts in the market maker
origin with the OCC, included in I.B. , determine their requirements
pursuant to the above sections on the basis of trades entered into
the clearance system by such specialist-market makers and registered
traders or on the basis of trades which have been matched by the
second pass on the day on which the trade was executed.

B. If the clearing firms requirements are determined
by trades entered, provide a description of each clearing
member's procedures for adjusting an account for trades that
remain unmatched by the final pass. Additionally, if such adjust-
ments would have increased the clearing firm's charges to net
worth or a specialist-market maker's or registered trader's equity
requirement, as of the day on which the trade was entered, what

is the clearing member's procedure or policy for reflecting such
additional deduction in its net capital computation and for obtaining
such additional deposits.

C. Provide a list of your organization's rules, and a
summary of each that govern the above procedures.

740

IV. Special Studies

741

June 7, 157.

Mr. ?hilli? J. LcJue
Jcnior vice President

facilic itocK iixenange, Inc.
61<J Scuta Jprir.3. ~treot

Calitcrnia *0'J14

Dear ilr. Loluer

In order to conduct its invest iqaticn ana. study c£ tha options
markets, it is necessary tnat the S-pecial iitucy 01 tiie utjticns .larxcts
("Options 5tudy) remjost tnat you ostein rrc;?. your raccr^s tne
financial cata ana other inior~aticn cescrioea in the sttachaent
to tnis letter relating to your tnenoers wni.cn are also .errors ot
tne Options Clear ing Corporation (-OCC-*) or wnicn conduct a ousinoss
solely or rrir.oriiy in standaraized octxens ana utilize tne facilities
of a clearing rae^^er. 1/

While \te understand tnat, in certain instances, part ot tne
information wnicn we are now requesting nay navs oeen suoaitted
previously to other divisions or ciiticcs ot tne Cocnission, wc
would appreciate it it you would suxciit duplicate copies ot such
documents to us in cruer to assure the completeness oi. tne Options
Study's own workinq tiles. In adaition, it such previous submissions
are not currently accurate, Please amend or upoate Lae:.-. cno continue
to inform tne Options otuoy statt when turther changes, it any,
are -pace in the procedures ana nractices c^scriocd in your submissions.
I£ rraterials requestea oy tnis letter nave oeen previously suor.ittca
to the Options Jtudy, in a £crm substantially as that requested hereoy,
it is not necessary to resubmit sucn materials. However, please state
the transmittal aste ana tne aaures3ee ct such prior submissions .

we appreciate tnat tni3 recuest :aay see* detailed intonation
wnich racv ta*e time and signir leant ettort on trio cart ct your statt
to conpile. However, tne Options Stuay snares tne oesire ot tne

1/ The authority £or this recuest is granted to the Ccr.jiissicn

pursuant to sections 17 ana 21 ot tne Securities Lxcnan^e Act ct
1^34. The Cc-raissicn is soliciting t.iis lntcriraticn to aid in:
(1) the enforcement ot tne Securities exchange />ci: and tne rules
ana regulations t/iereunocr ; (2) tne possible abortion ot rules
and regulations urner tne securities „xcnan~e Act; and (3) tne
estaoiisri.f.ant or an information l»se tro.m wnicn t.ie commission
nay rocormer.u turtJier legislation ccnccrninq ff-nttcrs to wiucn
thti securities ixcnarcie ".ct relates.

742

Mr. itftillio J. Lodue
?aqe Two

various c^lf-re^uiators that the activities or the Options Study be
completed in a tnocann and tinsly fashion. ^cccrdir.^'iy, while we
nave repeated that tne data er^ information reoue^tad in toe enclosed
attacsincnt ue sucoiied t>y July 7, 15'id, tnis snares CDJectivs woulo
ix facilitated it constituent elements ot tne attacn:.v3nt are promptly
rorwaroeo. to tne Options Stuuy L-eicre tnat deadline, lihculd tnere
De questions regarding this request, please call tne under signed
at (202) 7i:HL2o5.

Your cooperation is appreciated.

Sincerely,

Sober t L. Smith

Financial itesconsiDility and

Credit Specialist

Enclosures

743

Pacific Stock Exchange

Attachment to letter to
Dated June 7, 1978

Please submit the following information to: Special Study
of the Options Markets, Attn: Robert L. Smith, Securities and
Exchange Commission, 500 North Capitol Street, Washington, D.C.
20549.

Please submit your response in duplicate (excluding Forms A
and B).

I. Membership Information

A. Provide a list and the SEC file number, current as

B. For each person or organization identified in Item I. A.
above for which your organization is the designated examining authority
pursuant to 17 CFR 240.17d-l, complete Form A.

C. Provide, by clearing member, a list, current as of
March 31, 1978, of all persons or organizations registered as
broker -dealers for which each of those clearing members identified
in Item I.B. above clears options transactions, distinguishing
between those broker-dealers carried in the specialist-market
maker origin with the OCC from those carried in the customer origin.
For each such carried broker-dealer which is carried in the specialist-
market maker origin with OCC, state all its affiliations with
self-regulatory organizations and the capacities in which it

is registered to act with such self-regulatory organizations
including your organization.

744

D. With respect to each joint account trading in options
of which any participant is a registered broker-dealer, carried

E. Provide a list, current as of March 31, 1978, of all persons
or organizations registered as brokers or dealers which conduct a

a business in options on the floor of your exchange noting the
capacity in which such persons or organizations act (e.g. , specialist,
market maker, registered option trader, floor broker, independent
board broker, etc.) and whether such persons or organizations lease or
own their memberships. For each person or organization acting in a
dealer capacity on your options exchange and whose account was or
is carried by an 00C member pursuant to 17 CFR 240.15c3-l(a)(6) or
(c)(2) (x) on, or after, December 31, 1975, please complete Form B.

F. Provide the total aggregate equity, total deductions
required by 17 CFR 240.15c3-l and total net equity for all specialist-
market makers in options and registered options traders registered

II. Financial Responsibility Monitoring

A. Provide sample copies of all reports that your organization
receives to monitor the financial condition of the OCC members for
which your organization is the designated examining authority pursuant
to 17 CFR 240.17d-l which clear and finance the accounts of options
specialist-market makers and/or registered option traders or brokers,
and state the authority pursuant to which such reports are required
to be filed and the frequency of such reports. If any such designated
OCC clearing members are exempt from such reporting requirements, are
subject to a more frequent reporting cycle, or are subject to closer
than normal surveillance, state the firm and the reason.

745

III. Exchange Revenues

C. Provide for the periods noted in B. above option
related revenue as a percentage of total revenue and net option income
as a percentage of total net income.

IV. Unmatched Trades

A. Provide from the inception of standardized options trading
on your exchange, on a monthly basis, the following average daily
trade comparison system statistics:

1. The total number of (1) contracts, and (2) sides,
entered for comparison;

2. The total number of (1) contracts, and (2) sides,
which remained unmatched after the second trade matching
pass;

746

4. The total number of (1) contracts, and (2) sides,
which are matched in a matching cycle subsequent to the
final matching pass for the particular days transactions;
and

5. The percentage relationships the statistics
provided under 2, 3, and 4, bear to 1.

B. Describe whether, in computing their compliance with the
provisions of 17 CFR 240.15c3-l(a)(6) and 17 CFR 240.15c3-l(c)(2)(x),
OCC members which carry broker-dealer accounts in the market maker
origin with the OCC, included in I.B. , determine their requirements
pursuant to the above sections on the basis of trades entered into
the clearance system by such specialist-market makers and registered
traders or on the basis of trades which have been matched by the
second pass on the day on which the trade was executed.

is the clearing member's procedure or policy for reflecting such
additional deduction in its net capital computation and for obtaining
such additional deposits.

D. Provide a list of your organization's rules, and a
summary of each that govern the above procedures.

747

V. Commencement of Trading

VI. Special Studies

748

June I, 1^"/U

Mr. riichael A. r'ir.negan
ber.ior vice President
Philadelphia dtcc;'. fcxehengo. Inc.
17th dtreet and stock Sxcnange Place
Philadelphia, Pennsylvania Iyid3

Dear dr. Finnegan:

In order to conduct its invest iqat ion and study or the options
markets, it is necessary tnat tne Special Study 01 the Options dar*ets
("Options Study) request tnat you obtain fror.] voir records the
financial data &jvj otner information descried in t-.ie attochrcent
to tnis letter relating to your ns-sbers which are also ;r,3rr>ers of
the Options Clearing Corporation ("CCC") or wnicn conduct a business
solely or primarily in standardize options ana utilize the facilities
of a clearing merrider. 1/

While we understand that, in certain instances, part of tne
information wnicn we are now requesting snay nave been suorDittcd
previously to otner divisions or of rices of tne Cotnaii53ion, v;e
would appreciate it if you would suor.it duplicate copies of sucn
documents to us in order to assure tne completeness of tne options
Study's own working files. In addition, if such previous submissions
are not currently accurate, please oiTsend or update tnern anu continue
to inform tne Options Study staff when further changes, if any,
are node in the procedures and practices described in your submissions,
If materials reouesteu oy tnis letter nave been previously su.v.itteo
to tne Options study, in a forr.i substantially as that requested nereoy,
it is not necessary to resubmit such materials, dewever, nlesse suite
tne transmittal date and tne addressee of such prior submissions.

rie appreciate tnat this request nay seek detailed information
which raay take tine anu significant etiort on the pact of your staff
to compile. However, tne uptiens ^tuay snares tne desire of the

1/ Tne authority for tnis request is granted to the Coxnission

pursuant to Sections 1/ ana 21 ol tne Securities Exchange Act of
i.934. 'rhe Cor.mssion is soliciting tnis information to aid in:
(1) the enforcement of tne securities Exchange Act and the rule:.
and regulations tnercunuer? (t) tnet pessiole adoption or rules
and regulations under tne ^Securities cixcnancje ?\ctj an- (j) tne
establis.hr.ent or an intonation base from whicn the Copdission
may recoirjaonu further legislation concerning natters to whicn
tne Securities tsxchancie Act relates.

749

Mr. Michael A. ifinnegan
Page Two

various self-regulators tnat the activities of the Gotions Study ue
completed in a thorouqh unci ti.rely fasnion. ftccorcuuly, while we
have requested that tna data ana information requested in the enclosed
attachment be supplied by July V, 13 /6, this snared objective would

be facilitated i£ constituent elements or tne attacnr.ent are promptly
forwardej to tne Options Stuuy before that deadline. jp.ould t.i^ro
be questions regarding this request, plecje call tne undersigned
at (202) ?b5-12GJ.

Your cooperation is appreciated.

Sincerely,

Robert L. Smitn

Financial Responsibility ana

Credit Specialist

Enclosures

40-940 O - 79 - 50

750

Ph i 1 ado 1 ph ia St ock • Exchange

Attachment to letter to
Dated June 7 , 1978

Please submit the following information to: Special Study
of the Options Markets, Attn: Robert L. Smith, Securities and
Exchange Commission, 500 North Capitol Street, Washington, D.C.
20549.

Please submit your response in duplicate (excluding Forms A
and B).

I. Membership Information

A. Provide a list and the SEC file number, current as

B. For each person or organization identified in Item I. A.
above for which your organization is the designatel examining authority
pursuant to 17 CFR 240.17d-l, complete Form A.

C. Provide, by clearing member, a list, current as of
March 31, 1978, of all persons or organizations registered as
broker-dealers for which each of those clearing members identified
in Item I.B. above clears options transactions, distinguishing
between those broker-dealers carried in the specialist-market
maker origin with the OCC from those carried in the customer origin.
For each such carried broker-dealer which is carried in the specialist-
market maker origin with OCC, state all its affiliations with
self-regulatory organizations and the capacities in which it

is registered to act with such self-regulatory organizations
including your organization.

751

D. With respect to each joint account trading in options
of which any participant is a registered broker-dealer, carried

by a clearing memoer identified in Item I.B., identify all participants
in the account (including their SEC file number, if registered as
a broker-dealer) and, to the extent known, any other account in
which such participants maintain an interest, whether with that
clear inq member, another member of your organization or otherwise.

E. Provide a list, current as of March 31, 1978, of all persons
or organizations registered as brokers or dealers which conduct a

a business in options on the floor of your exchange noting the
capacity in which such persons or organizations act (e.g. , specialist,
market maker, registered option trader, floor broker, independent
board bro;?r, etc.) and whether such persons or organizations lease or
own their memberships. For each person or organization acting in a
dealer capacity on your options exchange and whose account was or
is carried by an OCC member pursuant to 17 CFR 240.15c3-l(a) (6) or
(c)(2)(x) on, or after , December 31, 1975, please complete Form B.

F. Provide the total aggregate equity, total deductions
required by 17 CFR 240.15c3-l and total net equity for all specialist-
market makers in options and registered options traders registered

G. Provide a list of all option specialist-market makers,
registered option traders, floor or board brokers and order book
officials which, since the inception of your standardized options
program, have withdrawn their registration as such and, to the
extent your files so reflect, provide a brief summary of the
circumstances.

II. Financial Responsibility Monitoring

A. Provide sample copies of all reports that your organization
receives to monitor the financial condition of the OCC members for
which your organization is the designated examining authority pursuant
to 17 CFR 240.17d-l which clear and finance the accounts of options
specialist-market makers and/or registered option traders or brokers,
and state the authority pursuant to which such reports are required
to be filed and the frequency of such reports. If any such designated
OCC clearing members are exempt from such reporting requirements, are
subject to a more frequent reporting cycle, or are subject to closer
than normal surveillance, state the firm and the reason.

752

III. Exchange Revenues

A. Provide, from the inception of standardized options
trading on your exchance, the schedule of all fees and dues
levied by the exchange its affiliations or subsidiaries applicable
to options business. Note each change in any item of such schedule
and the date of such revision. Also state the total amount received
or receivable for each item in such schedule, for each calendar
year in which your exchange has had a standardized options trading
program and for the first calendar quarter of 1978.

C. Provide for the periods noted in B. above option
related revenue as a percentage of total revenue and net option income
as a percentage of total net income.

IV. Unmatched Trades

A. Provide from the inception of standardized options trading
on your exchange, on a monthly basis, the following average daily
trade comparison system statistics:

1. The total number of (1) contracts, and (2) sides,
entered for comparison;

2. The total number of (1) contracts, and (2) sides,
which remained unmatched after the second trade matching
pass;

753

4. The total number of (1) contracts, and (2) sides,
which are matched in a matching cycle subsequent to the
final matching pass for the particular days transactions;
and

5. The percentage relationships the statistics
provided under 2, 3, and 4, bear to 1.

Also, provide an explanation of the procedures followed to
match trades that remained unmatched after the second trade matching
pass, and separately, for the final trade matching pa?-;. In addition,
provide separately, the most common reasons why these trades remained
unmatched after the second trade matching pass and the final trade
matching pass. In connection with these explanations describe any
studies that may have been conducted in this regard and any conclusions
that might be drawn therefrom.

B. Describe whether, in computing their comDliance with the
provisions of 17 CFR 240.15c3-l(a)(6) and 17 CFR 240.15c3-l(c) (2) (x) ,
OCC members which carry broker-dealer accounts in the market maker
origin with the OCC, included in I.B., determine their requirements
pursuant to the above sections on the basis of trades entered into
the clearance system by such specialist -market makers and registered
traders or on the basis of trades which have been matched by the
second pass on the d?.j on which the trade was executed.

is the clearing member's procedure or policy for reflecting such
additional deduction in its net capital computation and for obtaining
such additional deposits.

D. Provide a list of your organization's rules, and a
summary of each that govern the above procedures.

754

V. Commencement of Trading

VI. Special Studies

755

June 13, 1*79

Mr . ;<evin Daily
American otoc* ^xcnange
do Trinity r'laca
fteu YorK, Sew Vers; 10QU6

Dear Mr. Daily:

As I exniaine-i to you ever trie pncr.;> tnis woe.;, certain
rsocifications nave been T-3oe to ?aje 4 and page 3 of ^or^ A.

inese cnan<jc9 reelect discussions I have had vita you arsi t:
staff of otnor self-regulatory organisations. Sufficient ccoies
of pages 4 and 5 are enclosed to replace tncae previously sent.

Since tne changes reduce tne ssount of information tnat is
beini reouesteo iron your recoras it ia anticipated tnat your
organization './ill aeet Lie July 7, lwo uate for c>3 suaaissicn
of the recuesteu uata. If, nowever, you rind tnat tnis is net
possible oleaae contact the unoersi^ned at (202) 75S-1235.

Sincerely,

Robert L. Smith

financial Responsibility and

Credit Specialist

Enclosures :

756

June 16, ly'/'i

tic. riruce J. Simpson

executive Vice President

Chicaqo uoaru Oct ions c.xc.iange, Inc.

LaSalle at Jscsson

Chicago, Illinois 60604

Dear Ar. Simpson:

As I explained to you over the pnene this week, certain
nod if icat ions have been ssaae to page 4 and pace 5 of r^ora A,

These changes reflect discissions I have had with you snd tne
staff of other self-regulatory organizations. Sufficient copies
of panes 4 and 5 are enclosed to replace these previously senc.

Since tne cnanges reduce the amount of innervation that is
being recuested freni your recoros it is anticipated tnat your
organization will ;aeet tne July 7, 1976 date for tne suc&ission
of tne requested oata. If, however, you find tnat tnis is not
possible please contact the uncer signet, at (202) 7dd-12o3.

Sincerely,

Kobert L. Srdth
Financial Responsibility and
Creuit Soecialist

Enclosures:

757

June 16, 19 /b

rtr. Gar ola L'rcze
Director oi: tiori^er firms
Midwest Stock rixchange, Inc.
120 oouth LaJalle
Chicago, Illinois 60603

Dear Hr. Broze:

As I explained to you over the pncne tnis week, certain
nvooif ications have Deen Dade to pace 4 and page 5 or r'orm A.

These changes reflect discussions I nave had with you and the
staff of otner self-regulatory organizations. Sufficient copies
of pages 4 and 5 are enclosed to replace tncse previously sent.

Since the changes reduce tne airount of information tnat is
being requested frcm your records it is anticipated tnat your
organization will rseet the July 7, 1973 date for tne su^rtission
of the requested aata. If, however, you fino that t.iis is not
possible please contact the undersigned at (202) 755-1285.

Sincerely,

Robert L. Smith
Financial Responsibility and
Credit Specialist

Enclosures :

758

June lb, 19V o

iir. Jonn Pinto

vice t-rcijiuent

Surveillance Department

National Ae^cciaiiicn or, .Securities

Dealers, Inc.
1735 K Street, N.Vi.
meshing ten, D.C. 20 Gj?

Dear hr. Pinto:

As I explained to you over tne tSione tnis \,'eeK, certain
ratifications nave seen r^ade to cage 4 ana pa-7e 5 of *'or;T. A.

'Lliese ctxanges reelect discussions I have haO wicn you and ti»e
staff of ether self-requlatory organizations. Sufficient conies
ot pa'jes 4 and b are enclosed to replace t:;ose previously sent.

Since the ensngas reduce tne anvount of information that is
being requested ire;?, your reccras it is anticipated tnat your
organization will .reet tne July 7 , 157B date Lor trie :;uo:7US3 ion
of tne requester data. If, however, you find tnat tnis is not
possible please contact tiic undersigned at (2J2) 755-12o5.

Sincerely,

KolDart L» 5.~itii
financial Pesconsioility and
Credit Specialist

Enclosures:

759

June 16, 1973

Mr. John J. Senkewich
Assistant Vice President
New Yolk Stock Exchange, Inc.
55 Water Street
te?w York, Uew York 10041

Dear Mr. Senkewicn:

As I explained to you over the phone this week, certain
modifications have been made to page 4 and page 5 of Form A.

These changes reflect discussions I have had with you and the
staff of other self-regulatory organizations. Sufficient cooie3
of pages 4 and 5 are enclosed to replace those previously sent.

Since the changes reduce the acount of information that is
being requested frcm your records it is ant ideated that your
organization will meet the July 7, 1973 date for the submission
of the lecuested data. If, hov/ever, you find that this is not
possible please contact the undersigned at (202) 755-1235.

Sincerely,

Robert L. Snith
Financial Responsibility and
Credit Specialist

Enclosures :

cci Maurice Minnen

760

June 16, 1S>78

/«r. Due. lev tiuth

vice President

Ccr>pl iaace Do pa r t»nt

Pacific otccK lixcnanqe, Inc.

61 tf Soutn jprinq Jtreet

LC3 Angcies, Caiirornia 90014

Dear Mr. Suthi

As I explained to you over the phone this week, certain
asodificatiens nave been .naae to page 4 ana page j of fem A.

These cnanges reflect discussions I nave had with you and the
staff of ether self-regulatory organizations. Llutficient copies
of pages 4 and 5 are enclosed to replace those previously sent.

Since the chanqes reduce the azrount of infensation that is
being requested from your recorus it is anticipated tnat your
organization will ^eet tne July 7, 1973 date for tne suo-Tission
of the requested data. If, howsver, you rino tnat tnis is not
possible olease contact tne undersigned at (202) 756-1235.

Sincerely,

Robert L. &sith
Financial Responsibility ana
Credit specialist

Enclosures :

cc: Dennis Carlton

761
June 27, 1076

Mr. Druca J. Simpson

Executive vice President

Chicago Hoard dot ions Exchange, Inc.

La Salle at Jackson

Chicago, Illinois 60604

Dear Mr. Simpson:

1hi3 is to confirm the understand inq that we reached with
you and your staff on Jure 22, 1976 vitn regard to tns information
requested en r'on B attached to the letter to the Chicago Board
Options Lxchange, Inc. ("aiC£") dated June 7, 1978 from the
Special Study of the Options ,'iarkets (the -Study").

It is our understand inq , based on your staff's description,
thi't prior to January 1, 1S77, the effective date of certain
admendments to 17 Gr'R 24G.15c3-l(c) (2)(x) _1/ (Section (c)(2)(x)),
that the Options Clear inq Corp. ("OCC") members, tnat cleared,
carried end quaranteed (clearing memDers) the accounts of GiuS
options market makers, carried such accounts on a combined basis,
lhat is, the CCC clearing members combined all oven, market maker
accounts for the purpose of determininq cho total equity of all
accounts, not individually for each packet maker, in order to
determine their compliance with Section (c)(2)(x>. x\s such, I
understand that it would be an extrerely time consuminq project
for tne C3C£ to fully complete the 1975 and 1976 portions of torm a.

In view of the need for both timely and accurate data we
have determined that the CcCS need not complete corm B for the
periods 1S75 and 1976 exceDt for the -Equity and deficit" column
for the periods December 31, 1975, January 15, 1376 an j January
30, 1976. In addition we recuest that in lieu of the Eecemocr 31,
1976 data you suoply the data for all columns as of the first
business day of 1977, as well as for the other noted dates in 1977.

__!/ SEC Seleasc No, 34-1 27G6, dated September 2, 1976.

762

tfr. Bruce J,
Page l*/o

iinirBon

Lastly, we reouest that you suoply the Study v;ith the
aggregate ecuity in tha accounts of all options market makers
registered with your exchange as of the end of calendar years
19/3 and 1574 and the nuraber of such accounts for each such
period.

Sincerely,

Fobert L. Ssith
financial Besponsioility
& Credit Specialist

cc: William S. Ercdksy - ftMEX
Kenneth I. Fosenblun - tfSK
Michael A. Finnegan - £HLX
FhilliD J. Lofcue - PSE

763

Exhibit A

Spociai Jtudy of the Options Markets .(page 1 of 5)

Attnchnont to letter d.itcd June 7,1978

Options Study Form A
OCC CLEARING MEMBER INFORMATICS

(The information on this form is to be corrpilcd as of March 31, 1978,
unless otherwise noted. The term "member" as used herein shall include
"affiliated persons" as that term is defined by section 2(b) (2) of the
Investment Ccmcanv Act of 1940.)

1. Name of member: ' 2. SEC file No. 8-

3. Designated examining authority

4. Please indicate form of doing business:

Sole proprietorship / / Partnership / / Corporation / /

5. Please check the firm's affiliations:

a. American Stock Exchange * . / /

b. Boston Stock Exchange / /

c. Chicago Board Options Exchange / /

b. National Association of Securities / /
Dealers

d. Midwest Stock Exchange / /

e. New York Stock Ey change / /

f. Pacific Stock Exchange f~7

g. Philadelphia Stock Exchange . / /

i. Other securities exchange (s) Specify

j. Commodity exchange (s) Specify

764

Options Study Form A
OCC CLEARING MEMBER INK. ATICN

(page 2 of 5)

Name of firm

SEC file No. 8-

6. a. Please indicate the capacity in which the clearing member is registered
on each of the following securities exchanges:

Exchanqe

(1)

Options spec-*
ialist or
market maker

(2)

Options*

floor

trader

(3)

Options floor
broker or
board broker

(4)

Equity *
special-
ist

(5) "
Equity *
floor
trader

(6)

Equity

floor

broker

(7)
Other

(specify)

ASE

BSE

CBOE

MSE

CD *

CD'.

NYSE

CD-

PSE

CD '

-CD

Phlx •

CD
Other

(including foreign)
(specify)

* If the firm is registered as both an equity specialist (or equity floor trader)
and as an options specialist-market maker (or registered options trader) please attach
a list of the securities and options in which it is registered and on which exchange (s) ,
Please include the member's name and SEC file number at the head of the list.

b. If the clearing member i's registered on any commodity exchange, please specify
the exchange (s) and in what capacity :

765

Options Study Form A .. (page 3 of £)

OCC CLEAIUKC MEMBER INfOliNATION

Name oC firm SEC file N'o. 8-

7. Please indicate the nwrbcE of accounts (as of March 31, 1970) v.hich the
clearing rr/j^ber carried in each of the following categories:

Number of
accounts

a. .Public customer options accounts .

(1) Firm (other than introduced)

(2) Intr educed (fully disclosed)

(3) Omnibus (number of firms)

• b. All other public customer accounts

c. Options specialist-market makers

d. Equity specialist-market makers

e. Combined equity-options specialist-
market makers

f . Registered options traders

g. Registered equity traders

h. Combined registered equity-
options traders

i. Options floor broker accounts

j. Other broker-deilcr(s) proprietary omnibus
options accounts

k. Customer accounts introduced to another
broker-dealer

(1) Fully disclosed / /

(2) Omnibus /7

1. Please Fr°vide sample copies of all standard account agreements for each type
of account, included in 7 c. through 7 j. above, that the clc.\r Lng member
carries. Please include the firm's name and SEC file number, on each for:u.

1/ If possible, provide the number of individual customer options accounts

carried by the clearing member in all omnibus accounts:^

40-940 O - 79 - 51

766

Cptior.s Studv Form A
OCC CLEARING KE13ER INFORMATION

(page 4 of 5)

Kara of firm

SEC file No. 8-

Please provide the following information with respect to the clearing member firm 's
proprietary accounts as of the close of business on each trade date spccified:_l/

(a)

(b)

(c)

MARKET VALUE

(e)

Trade
date

1978-Apr 7

Long

option

positions

Shor t

option

positions

Long under-
lying equity
positions

Short under-
lying equity
positions

Gross
error
account 2>

\/ Omit pennies. If, during the period covered, the clearing member did not
have a position in a class of options in which it had a proprietary position
in the underlying securities, do not include the value of those position(s)
in columns (c) or (d).

2/ Including "out" accounts, suspense or difference accounts or any other
~" similar accounts for all long or short positions.

9. Please provide the market value of short option positions in the proprietary
accounts of the clearing member as of:

December 31 , 1976

December 30, 1977

767

IJas» of fiim

Options Study Form A
OCC CLEANING HBKEH ItCXKiATIOU

r.tx: file to.

(pcrje 5 of 5)

10. To the extent the firm cleared special ist-nai kct aafcci oi icjistoicd options trader

accounts during the following periods* please provide, as of the close ot business for

the dates sr/^cifi-.d below, the following: 1/

(a) . (b) (c) (d) 2/ (e) 3/ (f)2/

Net Net Excess Total Aggregate Net

worth capital net (a)(6) equity charges

capital & (c)(2)(r) to net

deductions worth

(OMIT PENNIES)

1976-Kai 31
Jan 30
Sep 30
Dec 31

1977-Mar 31
Jun 30
Sep 30
Dec 30

1978-Mar 31
Apr 17
Apr 23

1/ Omit pennies end indicate by n.r. if member was not registered for the date(s)
specified.

2/ As defined in 17CFR 240.15c3-l, paragraphs (a)(6) and (c)(2)(x). It should bo
noted that pt ior to January 1.1977, the effective date of certain amrruLrents to
fcilo 15c3-l(c)(2)(x), that section 15c3-l(c) (2) (xi) effectively set foi th the de-
ductions foi the accounts of legistcred options tiadeio and that section 13c3-l(a) (6)
regarding the 1,000 percent test was not effective until August 1,1977.

2/ In all options spccialist-nui ket maker and itviistcicd options trader accounts.

768

S.-kcIoI 'itudy of llic Opt lorn Markets
AttacxtM-nt to letter, dated Juie 7, 1«»7B

1. Name of

3. Floor

4. Cleared by_

Options Study form B
2. SBC file No. tt-

(naoc of exchange

5. SBC fUe Mo. 8-

(namo of firm)

6. Please Indicate form of doing business: Sole proprietorship {_ / Partnership / 7 Corporation / /

7. Indicate the capacity(s) in which the member is registered:

Options specialist ^ / Options market maker /~"7 Options trader /"**/ Options principal member / 7

a. To the extent a firm traded during these periods please provide the market value of following:

. Option positions Underlying security Equity or Total (a)(6) Net(a)(6)

Trade Long Short positions (deficit) t/or (c)(2)(x) &/<>r(c)(2)(x)

date Long Short deduct ions2/ charqes to

clearing
menbei2/3/

1975-Oec 31

1*76-Jan 15

Jan 30

Mar 31

Jun 30

Sep 30

Dec 31

lj>77-Mar 31

Jun 30

Sep 30

Dec 30

U7»-Har 31

Apr 12

. Apr 13

Apr 14

Atr 17

Apr lM

Apr 1»

Apr 20

Acr 21

tar 24

y Omit pennies and indicate by n.r. If

was not registered for the datc(s) specified.

2/ As defined in 17CFR 240.1Sc3-l, paragraphs (a)(6) and (c)(2)(x). It should be noted that
prior to January 1,1*77, the effective date of certain aremtacnts to Rule 15c3-l(c)(2)(x),
that sect ion lx3-l(c)(2)(xi) effectively set forth the deductions for the accounts of registered
options traders.

3/ If

equity, state

In parenthesis.

769

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Exhibit 7

BDARD DF BDVERNDRS

DF THE

FEDERAL RESERVE SYSTEM

WASHINGTON, D. C. 2QS51

OIVI8ION OF BANKING
SUPERVISION AND REQULATIOF

December 5, 1978

Mr. Richard L. Teberg
Director - Special Study of

the Options Market
Securities and Exchange Commission
500 North Capitol Street
Washington, D. C, 20549

Dear Dick:

This is in r
in which you discussed
model (the "delta mode
an underlying stock he
constitute a bona-fide
requirements of Regula
for our consideration
of the "delta model,"
of Economic Policy and

esponse to your letter, dated October 25, 1978

the use of the Black-Scholes option pricing
1") as a method for determining the amount of
Id by an options marketmaker which could

hedge for purposes of the specialist credit
tion T. With regard to this matter you enclosed
a paper reviewing the potential applications
which was prepared by the Commission's Directorate
Research .

At your request the Board's staff reviewed this paper along
with a number of other studies regarding the use of the "delta model"
as a risk management device. After careful study and analysis we
have concluded that it would be inappropriate to include the model
as part of the specialist credit provisions of Regulation T.

As you are aware, we are concerned that the level of
underlying stock held in a marketmaker ' s account not be excessive
in terms of that required by the marketmaker to fulfill his marketmaking
function in accordance with the objectives of Regulation T. These
objectives insofar as they relate to the use of preferential credit
by specialists, were first spelled out by the Board in discussions
with the New York Stock Exchange regarding its request that preferential
credit be given specialists on that exchange. In considering the
exchange's request the Board stated:

777

Mr. Richard L. Teberg

"The Board is, of course, interested in the orderly
and efficient operation of securities markets. It
is also concerned with the fact that rules of general
application such as those relating to margin require-
ments should not provide special concessions for any
individual or group unless such concessions are
justified by appropriate considerations that are 1/

consistent with the general purposes of the regulation."

In applying the Board's guidelines regarding the use of
specialist's credit to the purchase and sale of the underlying stock
by option marketmakers the staff has taken the position that preferential
credit is available only when such transactions are related to the
needs of the market and is unavailable in circumstances solely where
the marketmaker desires to minimize the risk in his account. In this
regard the staff believes that the use of the "delta model" would
not reduce the use of preferential credit in connection with the
purchase and sale of the underlying security but, in fact,
may tend to increase it as marketmakers attempt to invest in optimal
risk-minimizing strategies which may be unrelated to their responsi-
bilities to the public market. This problem would be especially acute
in circumstances where the marketmaker held an underlying securities
position which had decreased in value. Under such circumstances the
marketmaker, might be reluctant to dispose of that position in the
event it no longer served as a bona-fide hedge. Rather, in an attempt
to minimize his costs, he would prefer to initiate transactions in
options to re-establish his hedge without considering fully the needs
of the public market. Furthermore, since exchange rules generally
restrict a customer's ability to purchase or sell out of the money
options, in circumstances where marketmakers initiated transactions
in these securities to re-establish a hedge, the use of a "delta model"
would have the added drawback of increasing the relative amount of
professional trading in an option series with questionable benefits
accruing to the investing public.

The staff is also concerned that the use of the "delta
model" as a formalized part of Regulation T would sharpen the
conflict which the staff believes currently exists between a
marketmaker 's obligation to the market he serves and his desire to
become "delta neutral" in order to minimize his risk. As indicated above
the specialist credit provisions of Regulation T were adopted to assist
the marketmaker in performing his marketmaking function. We understand
that one of the marketmaker 's principal obligations in performing his
function is to take risks "against the market". Incorporation of the

1/ Letter of the Board to Erail Schram, President of the New York
Stock Exchange dated March 14, 1949.

778

Mr. Richard L. Teberg

"delta model" into the specialist credit provisions of Regulation T
would appear to discourage a marketmaker from assuming these risks
since if he did so, he might break his "delta neutrality" and increase
his margin requirement.

In summary it is the staff's view that the application of
the "delta model" in the area of specialist's credit would be
inconsistent with the overall objectives of Regulation T. The staff
recognizes of course that the risk minimizing attributes of the
"delta model" make it attractive for purposes of the uniform net capital
rule should the Commission staff desire to apply the model in this area.

We appreciate the opportunity to comment on this matter
and hope that our comments are useful to you. If you have any further
questions, please do not hesitate to call.

Very truly yours,

(lA^2&^

Robert S. Plotkm
Assistant Director

CHAPTER VIII

ISSUES OF STRUCTURE IN THE
STANDARDIZED OPTION MARKETS

I. INTRODUCTION

When announcing the initiation of the Special Study of the Options
Markets, _1/ the Commission expressed its view that "experience with existing
pilot options trading programs has not yielded answers to certain general
questions bearing upon the future of standardized options trading." _2/
More specifically, the Commission stated its concerns regarding "how
to develop standards by which to gauge, on a case-by-case basis, the
appropriateness of particular self-regulatory organization proposals
to expand options trading" and "how [standardized options] trading can
or should be comprehended within the national market system for securities
contemplated by the [Securities Exchange] Act." _3/

At the time of the Commission's announcement, the National Asso-
ciation of Securities Dealers ("NASD") 4/ and the New York Stock Exchange

1/ The Special Study of the Options Markets will be referred to as the
"Options Study" in this chapter.

_2/ Securities Exchange Act Release No. 14056 (October 17, 1977),
13 SEC Docket 366, 369 (November 2, 1977).

_3/ Id.

_4/ SR-NASD-77-2 ("NASD Plan"). The Commission gave notice of the NASD
Plan in Securities Exchange Act Release No. 13230 (February 1, 1977)
11 SEC Docket 1630 (February 15, 1977).

(779)

780

('NYSE") _5/ had filed proposals to begin standardized options trading
programs and the Chicago Board Options Exchange ("CBOE") _6/ had requested
permission to commence trading in equity and other non-option securities.
In addition, CBOE, the American Stock Exchange ("AMEX"), the Midwest Stock
Exchange ("MSE"), and the Pacific Stock Exchange ("PSE") had proposed to list
standardized options on underlying securities traded exclusively in the
over-the-counter markets, 7/ and the Philadelphia Stock Exchange ("PHLX")
and PSE had requested permission to eliminate the physical barriers existing
between their stock and options trading floors. _8/ Further, MSE and PSE
had proposed to permit individuals to hold simultaneous marketmaker appoint-
ments in listed options and their underlying securities under certain

_5/ SR-NYSE-77-17 ("NYSE Plan"). The Commission gave notice of the NYSE
Plan in Securities Exchange Act Release No., 13674 (June 24, 1977),
12 SEC Docket 1014 (July 12, 1977).

_6/ SR-CBOE-77-14 ("CBOE Plan"). The Commission gave notice of the CBOE
Plan in Securities Exchange Act Release No. 13672 (June 24, 1977),
12 SEC Docket 1012 (July 12, 1977).

JJ SR-PSE-76-17; SR-CBOE-76-16; SR-AMEX-76-28 ; SR-MSE-77-4. The Commission
gave notice of these proposed rule changes in Securities Exchange Act
Release No. 12539 (June 11, 1976), 9 SEC Docket 876 (June 30, 1976);
No. 12703 (August 12, 1976), 11 SEC Docket 221 4 August 12, 1976);
No. 13095 (December 22, 1976), 11 SEC Docket 1269 (January 11, 1977);
and No. 13406 (March 25, 1977), 11 SEC Docket 2150 (April 12, 1977).

_8/ SR-PHLX-77-6 ; SR-PSE-77-13. The Commission gave notice of these proposed
rule changes in Securities Exchange Act Release No. 13689 (June 23,
1977), 12 SEC Docket 1037 (July 12, 1977), and No. 13567 (May 23,
1977), 12 SEC Docket 471 (June 7, 1977).

781

circumstances. 9/ Finally, NYSE had proposed to rescind current re-
strictions on option trading by its stock specialists and registered stock
marketmakers. 10/ Each of these proposals presented significant issues
concerning the structure of the standardized options markets and the
markets for their underlying securities. 11/

This chapter will discuss some of the issues that these proposals
present with a view toward developing an analytical framework, formulated
with reference to the purposes of the Securities Exchange Act ("Exchange
Act"), within which to measure the appropriateness of these and similar
proposals. It will present various factors that should be considered when
evaluating such proposals, but will not present specific recommendations
with respect to whether the Commission should approve or disapprove any
particular proposal. 12/ The chapter will first discuss the statutory

_9/ SR-MSE-77-28 ; SR-PSE-77-17. The Commission gave notice of these
proposed rule changes in Securities Exchange Act Release No. 13707
(June 30, 1977), 12 SEC Docket 1101 (July 19, 1977), and No. 13725
(July 7, 1977), 12 SEC Docket 1119 (July 19, 1977).

10/ SR-NYSE-76-54. The Commission gave notice of this proposed rule
change in Securities Exchange Act Release No. 12924 (October 27,
1976), 10 SEC Docket 786 (November 9, 1976).

11/ These proposals, with the exception of SR-NYSE-76-54, were voluntarily
withdrawn subsequent to the initiation of the Options Study pursuant
to an agreement among the Commission and the self -regulatory organi-
zations participating in the moratorium. However, each of the
proposals may be resubmitted after January 1, 1979 provided that
the Commission and other affected self -regulatory organizations
are given sixty days advance notice. See Securities Exchange Act
Release No. 14878 (June 22, 1978), 15 SEC Docket 98 (July 5, 1978).

12/ Since these proposals are not pending before the Commission and may
ultimately be submitted in revised form, recommendations concerning
the specific proposals would be inappropriate at this time.

40-940 O - 79 - 52

782

standards that should be applied when evaluating issues such as those that
the proposals raise. It will then discuss (i) whether, and under what
circumstances, standardized options of the same class, expiration date,
and exercise price should be traded in more than one marketplace, (ii)
the extent to which the trading of standardized options and their underlying
securities should be integrated, (iii) whether, and under what circumstances,
standardized options should be traded in the over-the-counter markets,
(iv) whether, and under what circumstances, the trading of standardized
options should be permitted on the NYSE, and (v) the steps the Commission
should consider at this time to assure that the standardized options markets
evolve in a manner which is consistent with the public interest in perfecting
the mechanisms of a national market system.

II. THE STATUTORY STANDARDS

A. A National Market System

1. A National Market System and SEC Authority
The Securities Acts Amendments of 1975 (the "1975 Amendments" or the
"Amendments") 13/ established as a purpose of the Exchange Act 14/ the

13/ Pub. L. No. 94-29 (June 4, 1975).
14/ 15 U.S.C. 78a et seq.

783

need "to remove impediments to and perfect the mechanism of a national

market system for securities." 15/ The Exchange Act, as amended, provides

The Commission is directed * * *, having due regard
for the public interest, the protection of investors,
and the maintenance of fair and orderly markets, to
use its authority under [the Exchange Act] to
facilitate the establishment of a national market
system for securities (which may include subsystems
for particular types of securities with unique
trading characteristics) in accordance with the
findings and to carry out the objectives set forth
in paragraph (1) of [Section HA(a)]. The Commission,
by rule, shall designate the securities or classes
of securities qualified for trading in the national
market system from among securities other than
exempted securities. (Securities or classes of
securities so designated hereinafter * * * referred
to as 'qualified securities.') 16/

The 1975 Amendments did not define a national market system. Rather,

the Congress granted "broad, discretionary powers [to the Commission] to

oversee the development of a national market system and to implement its

specific components in accordance with the [Congressional] findings

and to carry out the objectives set forth [in the Exchange Act]." 17/

The Amendments were designed to provide ''maximum flexibility to the

Commission and the securities industry in giving specific content to

15/ Section HA(a)(2) of the Exchange Act [15 U.S.C. 78k-l(a) (2)] .

16/ Id.

17/ Senate Committee on Eanking, Housing and Urban Affairs, Report to
Accompany S. 249, S. Rep. No. 94-75, 94th Cong., 1st Sess. 7
(1975) ("Senate Report").

784

the general concept of the national market system," 18/ and a national

market system was to "evolve through the interplay of competitive forces

as unnecessary regulatory restrictions are removed." 19/ The Congress

expected, however, that "in those situations where competition may not

be sufficient, * * * the Commission will use the powers granted to it

* * * to act promptly and effectively to insure that the essential

mechanisms of an integrated secondary tradinq system are put into

place as rapidly as possible." 20/ As the Senate Committee stated:

[A] fundamental premise of the bill is that the
initiative for the development of the facilities
of a national market system must come from private
interests and will depend upon the vigor of competition
within the securities industry as broadly defined.
Although the SEC's basic role would be to remove
burdens on comoetition which would unjustifiably
hinder the market's natural economic evolution and
to assure that there is a fair field of competition
consistent with investor protection in situations
in which natural comrjetitive forces cannot, for
whatever reason be relied upon, the SEC must assume
a special oversight and regulatory role. 21/

A national market system was intended to encompass "all segments

of the corporate securities markets including all types of common and

18/ Committee of Conference, Report to Accompany S. 249, H.R. Reo. No.
94-249, 94th Cong., 1st Sess. 92 (1975) ("Conference Report").
See also Senate Report, supra , n.17, at 7-9.

19/ Conference Report, supra, n.18, at 92.

20/ Id.

21/ Senate Report, supra, n.17, at 12. See also House Committee on
Interstate and Foreign Commerce, Report to Accompanv H.R. 4111,
H.R. Rep. No. 94-123, 94th Cong., 1st Sess. 44 (1975) ("House
Report" ) .

785

preferred stocks, bonds, debentures, warrants and options." 22/ This
was deemed desirable because many of the goals of a national market
system were considered to be "nearly universal in scope and might not
be fully realized within separate market systems." 23/ However, the
Amendments did not seek to "ignore or eliminate distinctions between
exchange markets and over-the-counter markets or other inherent differences
or variations in the components of a national market system" or to
"force all markets for all securities into a single mold." 24/ Instead,
the Congress recognized that the "unique characteristics of other
securities * * * may require treatment different from that for listed
common stocks" 25/ and, as a result, gave the Commission authority and
flexibility to establish "subsystems within the national market system
which are tailored to the characteristics of the Darticular types of
securities which are to be traded in each subsystem." 26/

22/ Senate Report, supra, n.17, at 7. See also Conference Report,
supra, n.i.8, at 92.

23/ Id.

24/ Id.

25/ Conference Report, supra, n.18, at 92-93.

26/ Id., at 93. See alL Senate Report, supra, n.17, at 7.

786

2. Objectives of a National Market System
Section HA(a)(l) of the Exchange Act states the Congressional findings
that:

(A) The securities markets are an important national
asset which must be preserved and strengthened.

(B) New data processing and communications tech-
niques create the opportunity for more efficient and
effective market operations.

(C) It is in the public interest and appropriate for the
protection of investors and the maintenance of fair and
orderly markets to assure —

(i) economically efficient execution of
securities transactions;

(ii) fair competition among brokers and
dealers, among exchange markets, and
between exchange markets and markets
other than exchange markets;

(iii) the availability to brokers, dealers,
and investors of information with respect to
quotations for and transactions in securities;

(iv) the practicability of brokers executing
investors' orders in the best market; and

(v) an opoortunity, consistent with the
provisions of clauses (i) and (iv) of this
subparagraph, for investors' orders to be
executed without the participation of a
dealer .

(D) The linking of all markets for qualified securities
through communication and data processing facilities
will foster efficiency, enhance competition, increase
the information available to brokers, dealers and

787

investors, facilitate the offsetting of investors' orders,
and contribute to best execution of such orders. 27/

These are the essential "goals and objectives of a national market system
for qualified securities." 28/

More specifically, a primary objective of the national market
system is "the centralization of all buying and selling interest so
that each investor will have the opportunity for the best possible
execution of his order, regardless of where in the system it originates." 29/
The 1975 Amendments established "a clear Congressional policy supporting
the preservation and extension of the protections associated with auction-
type trading for appropriate securities under appropriate circumstances" 30/
and had "as a fundamental goal the elimination of fragmented markets for
securities suitable for auction trading." 31/ In this regard, the Senate
Committee stated:

The Committee found that public investors could
enjoy two important benefits when trading in an
ideal auction-type market for securities as opposed
to a purely dealer market: (1) Their limited price
orders would have to be satisfied before any trans-

27/ 15 U.S.C. 78k-l(a)(l).

28/ Senate Report, supra , n.17, at 8.

29/ Senate Report, supra, n.17, at 7. See also House Report, supra ,
n.21, at 50-51.

30/ Id., at 18.

31/ Senate Report, supra, n.17, at 17. See also House Report, supra,
n.21, at 50.

788

action could be effected at the same price, by a
specialist or other market maker for his dealer
account, or by the customer's broker for the latter' s
proprietary account, or by any participant in that
market at a price less favorable to the other party;
and (2) Their market orders could be executed against
another public limit or market order at a better
price than that currently being quoted by any dealer
for his own account.

[Exchange auction trading rules] protect public
investors against prearranged trades that do not secure
the best execution available and against the payment of
a spread to a dealer. However, because the market for
most listed securities is fragmented, i.e., conducted
on several exchanges as well as in the third market, the
value of this protection is considerably less than it
might appear. For example, a limited price order is presently
"protected" as to price priority on the exchange on which
it is held but it is not protected in any way [with] respect
to trading on another exchange or in the third market.
As a consequence, a limit order for a listed security
held in only one of several markets for that security
need not be executed before a transaction is effected
at the same price or at a price less favorable to the
other party in another market. In the Committee's view
this is the basic problem caused by the fragmentation
of the securities markets: the lack of a mechanism by
which all buying and selling interest in a given security
can be centralized and thus assure public investors best
execution. Until such centralization is accomplished,
the protections and benefits of the auction market will
remain limited. * * * Therefore, the Committee believes
that to eliminate market fragmentation and thus to achieve
a true national market system, a set of trading rules
and Drocedures must be adopted which will tie the individual
market centers together. 32/

32/ Id., at 16-17.

789

Another of the "fundamental Durposes underlying the national
market system * * * is to enhance the comoetitive structure of the
securities markets in order to foster the risk-taking function of
market makers and thereby to orovide free market incentives to active
participation in the flow of orders." 33/ h "healthy, highly competitive
system of market makers" was considered "essential to an efficient
national market system." 34/ The Congress expressed its view that
many types of market makers are necessary" to assure that the securities
markets are able to meet the needs of individual and institutional
investors and that "encouragement should be given to all dealers
to make simultaneous markets within the new national system." 35/
Moreover, the Congress expected that the "competitive structure and
incentives" to engage in marketmaking activities that would accompany
the establishment of a national market system "should suDplement,
and ultimately may be able to replace, most affirmative requirements
to deal imposed by regulation." 36/

33/ Id., at 14. See also House Report, supra, n.21, at 50.

34/ Id.

35/ Id.

36/ Id.

790

3. The Elimination of Unnecessary Regulatory Restrictions
To achieve the objectives of a national market system, the Congress
called upon the private sector, under the supervision of the Commission,
to develop and implement communication and data processing equipment to
create a "single integrated [securities trading] system." 37/ The
Commission's primary responsibility is "to remove burdens on competition
which would unjustifiably hinder the market's natural economic evolution
and to assure that there is a fair field of competition, consistent with
investor protection, in situations in which natural competitive forces
can not, for whatever reason, be relied upon * * * ." 38/ Accordingly,
the Amendments charged the Commission "with an explicit and pervasive
obligation to eliminate all present and future competitive restraints
that [can]- not be justified by the purposes of the Exchange Act," 39/
and directed the Commission "to remove existing burdens on competition
and to refrain from imposing, or permitting to be imposed, any new
regulatory burden on competition 'not necessary or appropriate in
furtherance of the purposes' of the Exchange Act." 40/

37/ Id., at 9. See also Conference Report, supra, n.18, at 92.

38/ Id., at 12. See also Conference Report, supra, n.18, at 94-95
and House Report, supra , n.21, at 49-51.

39/ Id., at 13. See also Conference Report, supra, n.18, at 94-95.

40/ Conference Report, supra, n.18, at 94.

791

Accordingly, Sections 6(b)(8), 41/ 19(b) 42/ and 19(c) 43/ of
the Exchange Act were amended to obligate the Commission to review
self-regulatory organization rules and to abrogate or disapprove
rules which have or would have the effect of placing a burden on com-
petition that is neither necessary nor appropriate in furtherance
of a legitimate regulatory objective. 44/ Similarly, Section 23(a) 45/
requires the Commission to evaluate its own regulatory proposals
"in light of the fundamental national economic policy of furthering
competition" 46/ and prohibits the Commission from adopting any rule
or regulation "which would impose a burden on competition not necessary
or appropriate in furtherance of the purposes of [the Exchange Act] ." 47/
Under each of these sections, the Commission's responsibility is "to
balance the perceived anti-competitive effects of [a] regulatory policy
or decision at issue against the purposes of the Exchange Act that

41/ 15 U.S.C. 78f(b)(8).

42/ 15 U.S.C 78s(b).

43/ 15 U.S.C 78s(c). See also Section 31(b) of the 1975 Amendments,
Pub. L. 94-29, Section 31(b) (June 4, 1975).

44/ Conference Report, supra , n.18, at 94; Senate Report, supra , n.17,
at 13.

45/ 15 U.S.C. 78n(a)(2).

46/ Senate Report, supra, n.17, at 13.

47/ 15 U.S.C. 78n(a)(2).

792

would be advanced thereby and the costs of doing so." 48/ While the
Commission is not required to justify its actions as "the least anti-
competitive manner of achieving a regulatory objective," the Commission
must "weigh competitive impact in reaching regulatory conclusions." 49/
As the Senate Report stated:

Competition would not * * * become paramount
to the great purposes of the Exchange Act,
but the need for and effectiveness of regulatory
actions in achieving those purposes would have
to be weighed against any detrimental impact
on competition. 50/

4. Communication Among and Dissemination of Information
About Securities Markets

Section llA(b) and (c) of the Exchange Act gives the Commission direct

jurisdiction over certain persons or organizations engaged in the business

of collecting, processing, or publishing information relating to quotations

for, indications of interest to purchase and sell, and transactions

in securities. 51/ In particular, subsection llA(c) was designed to

"give the Commission extensive power to develop and regulate the national

market system and the activities of persons involved in that system,"

48/ Senate Report, supra , n.17, at 13-14. See also Conference Report,
supra , n.18, at 94.

49/ Id., at 13.

50/ Id., at 14. See also Conference Report, supra , n.18, at
94-95.

51/ 15 U.S.C. 78k-l(b), (c).

793

and the Commission's rule-making authority under the subsection

extends to:

* * * facilitating the development of a composite tape
and composite quotation system, determining the
occasion for suspension of the operation of a tape
or quotation system with respect to particular
securities, establishing performance standards for
securities information processors, prescribing the
terms and conditions for retransmission of info-
mat ion collected by any exclusive processor,
preventing the use or publication of fraudulent,
deceptive, or manipulative market information,
and integrating information services and market
facilities. 52/

The Commission's direct regulatory authority under subsection

llA(c)(l) was intended to assure that the Commission would "play an

effective leadership role in the establishment and regulation of a

national market system." 53/ Accordingly, subsection llA(c)(l) provides:

(c)(1) No self-regulatory organization, member
thereof, securities information processor, broker,
or dealer shall make use of the mails or any means
or instrumentality of interstate commerce to
collect, process, distribute, publish, or prepare
for distribution or publication any information
with respect to quotations for or transactions in
any security other than an exempted security, to
assist, participate in, or coordinate the distri-
bution or publication of such information, or to
effect any transaction in, or to induce or
attempt to induce the purchase or sale of, any
such security in contravention of such rules and

52/ Senate Report, supra , n.17, at 103-104. See also Conference
Report, supra , n.18, at 93.

53/ Id.

794

regulations as the Commission shall prescribe as necessary
or appropriate in the public interest , for the protection
of investors, or otherwise in furtherance of the
purposes of [the Exchange Act] to —

(A) prevent the use, distribution, or publication of
fraudulent, deceptive, or manipulative information with
respect to quotations for and transactions in such
securities;

(B) assure the prompt, accurate, reliable, and fair
collection, processing, distribution, and publication
of information with respect to quotations for and
transactions in such securities and the fairness and
usefulness of the form and content of such information;

(E) assure that all exchange members, brokers, and
dealers transmit and direct orders for the purchase or
sale of qualified securities in a manner consistent with
the establishment and operation of a national market
system; and

(F) assure equal regulation of all markets for qualified
securities and all exchange members, brokers, and dealers
effecting transactions in such securities. 54/

With respect to subsection (E), the Senate Report stated:

[T]he Commission would be required to assure that
any order transmission or "switching" system utilized
by a brokerage firm or an exchange operates in a
manner consistent with the development and operation
of a national market system. Large brokerage firms
rely heavily on high speed systems for the direction
of orders to a designated facility for execution.
The Committee has been informed that many of these
systems are currently geared to route orders for any
particular security to only one market center, e.g.,

54/ 15 U.S.C. 78k-l(c)

795

the NYSE. The functioning of such systems in this
manner is inconsistent with the development and
operation of a national market system. It may also
be inconsistent with a broker's obligation to
obtain "best execution" for his customers. The
subsection would accordingly give the SEC the
responsibility to require brokers to utilize
order switching services which are "neutral"
as to market centers, giving preference to one
execution facility over another only to insure
best execution. 55/

5. Multiple Trading
Multiple trading is the trading of a security in more than one
marketplace. Multiple trading may occur as a result of listing a
security on more than one exchange, through the grant of unlisted trading
privileges, or as a result of trading listed securities in the over-
the-counter markets. Since 1934, the Commission has generally encouraged
the development of competitive markets for securities listed on the
NYSE. Traditionally, this has been done by facilitating the trading
of these securities on regional exchanges pursuant to "unlisted trading
privileges." Under Section 12(f)(1) of the Exchange Act, if a security
is listed on one exchange, any other exchange may initiate trading
in that security merely by obtaining the permission of the Commission.
The Exchange Act also requires that the Commission grant an application
for unlisted trading privileges with respect to a listed security
if the Commission finds, after appropriate notice and opportunity

55/ Senate Report, supra, n.17, at 104-105. See also House Report,
supra, n.21, at 41, 92.

796

for hearing, that the application is "consistent with the maintenance

of fair and orderly markets and the protection of investors." 56/

As the Senate Report observed, the Commission has usually granted

applications for unlisted trading privileges involving securities

already listed on at least one exchange "as a matter of course," 57/

and the 1975 Amendments supported this approach. 58/ The Congress

viewed unlisted trading privileges, and consequently multiple exchange

trading of listed securities, "as appropriate to a national market

system in which all market makers and brokers are permitted to deal

freely with one another without unnecessary regulatory constraints." 59/

As the Senate Securities Industry Study stated:

Since the imposition of federal regulation in
1934, the SEC has consistently taken a position
in favor of the competitive trading of listed
securities in multiple markets * * * . It has
also resisted efforts by the NYSE to prevent
its members from dealing in such dually- traded
securities on these other exchanges. The Sub-
committee believes that restriction of trading
in securities to a single market is a drastic
measure, to be legislated only when the public
interest clearly requires it. 60/

56/ Section 12(f)(1) of the Exchange Act [14 U.S.C. 781(f)(1)],

57/ Senate Report, supra , n.17, at 19.

58/ Id., at 106.

59/ Id., at 20.

60/ Subcomm. on Securities of the Senate Comm. on Banking, Housing
and Urban Affairs, Securities Industry Study, 93rd Cong., 1st
Sess. 121 (1973) (footnotes omitted).

797

B. The Basic Statutory Goals

The 1975 Amendments sought to assure that the securities markets
and the regulation of the securities industry "remain strong and capable
of fostering [the] fundamental goals [that the Exchange Act established]
under changing economic and technological conditions." 61/ However,
the Amendments left unchanged the basic goals of the Exchange Act:
to protect investors and the public interest, to provide fair and honest
mechanisms for the pricing of securities, to assure that dealing in
securities is fair and without undue preferences or advantages among
investors, to ensure that securities can be purchased and sold at
economically efficient transaction costs, and to provide, to the
maximum degree practicable, markets that are free, open and orderly. 62/

While none of these terms is defined in the Exchange Act, the Report
of the Special Study of Securities Markets provided insight into the
"general significance and thrust" of some of them. 63/ As the
Special Study explained:

61/ Conference Report, supra, n.18, at 92.

62/ Id., at 91-92. See, e.g., Sections 2, 6(a), 6(b)(5), 9, 10,
llA(a)(l)(C), HA(a)(2), llA(b), HA(c), 15A(a) , and 15A(b)(6)
of the Exchange Act [15 U.S.C. 78b, f(a), f(b)(5), i, j, k-l(a) (1)(C) ,
k-l(a)(2), k-l(c), o-3(a), o-3 (b)(6)].

63/ Report of the Special Study of Securities Markets of the Securities
and Exchange Commission, Part 2, H.R. Doc. No. 95, 88th Cong., 1st
Sess. 14 (1963) ("Special Study1).

40-940 O - 79 - 53

798

"Fair" and "honest" presumably encompass the notion
of freedom from manipulative and deceptive practices
of all kinds and may be regarded as positive expressions
of the [Exchange Act's] ban on such practices, acts and
devices. "Fair" also presumably implies, especially in
the several references to "fair dealing" and also the
reference to "unfair discrimination between customers
or issuers , or brokers or dealers , " that there be no
undue advantage or preference among participants in
the marketplace; i.e., that there be no unnecessary
discrimination in opportunity or treatment or in
access to facilities or information. As among parti-
cipants within any properly recognized category — those
making similar uses of, contributions to, and demands
upon the market facilities — discrimination would
be altogether unacceptable. As between different
categories — where different uses, contributions,
or demands might appropriately be recognized —
differences in opportunity and treatment would be
held to the absolute minimum consistent with the
recognized differences. In short, a market which
recognized any improper categories or permitted any
unwarranted discriminations would not be considered
"fair" in the fullest sense.

"Free" presumably implies that the forces of supply
and demand should operate without interjection of
artificial factors. Insofar as the extraneous
factors might be manipulative, the concept overlaps
that of fairness. But "free," in its ultimate sense,
may go further to exclude extraneous forces of a
beneficent (i.e., stabilizing or market ordering)
nature. In the latter sense a completely "free"
market would be permitted to affect prices regardless
of the sharpness or duration of the resulting move-
ments. "Open" presumably implies that anyone can
enter the market to buy and sell. * * *

"Orderly" presumably implies efficiency and economy
of operations, but also embraces concepts of
regularity of operation — "a market which does not
'fold up1 when the pressure on dealers becomes
too heavy" and the concept of avoidance of wide
price swings within relatively short spans of time.

799

In the sense of efficiency, "orderly" might include
the degree of assurance, through available market
mechanisms, that the highest bidders and lowest
offerors do not miss each other to the disadvan-
tage of both [and] * * * may also imply constancy
over periods of days or weeks; i.e., a degree of
stability. 64/

In this regard, it should be noted that the Exchange Act requires

that each registered national securities exchange and association

be organized and have the capacity "to carry out the purposes of [the

Exchange Act] and to comply, and * * * to enforce compliance by its

members and persons associated with its members, with the provisions of

[the Exchange Act], the rules and regulations thereunder," and the rules

of the exchange or association. 65/ The Exchange Act also requires that

the rules of registered securities exchanges and associations be designed

"to prevent fraudulent and manipulative acts and practices, to promote

just and equitable principles of trade, * * * to remove impediments to

and perfect the mechanism of a free and open market and a national market

system, and, in general, to protect investors and the public interest." 66/

64/ Id., at 14-15 (footnotes omitted).

65/ Sections 6(b)(1) and 15A(b)(2) of the Exchange Act [15 U.S.C.
78f(b)(l); 15 U.S.C. 78o-3(b) (2)] .

66/ Sections 6(b)(5) and 15A(b)(6) of the Exchange Act [15 U.S.C.
78f(b)(5); 15 U.S.C. 78o-3(b) (6)] .

800

III. THE MULTIPLE TRADING OF STANDARDIZED OPTIONS

On February 1, 1973, the Commission granted the application of

CBOE for registration as a national securities exchange. 67/ In

approving the CBOE application, the Commission stated:

Since the CBOE is a new exchange, and the first
national securities exchange proposing to provide
for the trading of puts, calls, or similar options,
we have determined to permit it to test the market
for such options within a controlled environment.
CBOE has stated that it intends to commence operations
as a "pilot project" and limit trading on its floor
initially to call options in respect of approximately
30 underlying stocks, and increase the number of
underlying stocks gradually and extend operations
to other types of options as experience is gained
and the market and its regulatory arrangements are
tested. 68/

Thus, standardized option trading began in a "controlled environment" in

which a limited number of call options were traded on one exchange.

Later in 1973, AMEX and PHLX expressed interest in initiating options

trading programs. Although the Commission had received a report from the

CBOE covering its first three months of operations, the Commission was of the

view that the report was "inconclusive on a number of major questions" 69/ and

67/ Securities Exchange Act Release No. 9985 (February 1, 1973),
1 SEC Docket 11 (February 13, 1973).

68/ Id.

69/ Securities Exchange Act Release No. 10490 (November 14, 1973)
3 SEC Docket 39, 40 (November 27, 1973).

801

concluded that further study was necessary to resolve many of the issues that
the CBOE "pilot project" and the plans of AMEX and PHLX presented. 70/
In particular, the Commission noted that AMEX and PHLX intended "to trade
options having the same underlying issuers as some options which are
traded on the CBOE" and announced that it had "not made any definitive
determinations with respect to a number of basic questions concerning
options trading on exchanges, including whether options should be traded,
on a pilot basis or otherwise, on more than one exchange * * * ." 71/
To aid the Commission in its consideration of the AMEX and PHLX proposals,
the Commission requested public comments with regard to "whether (and, if
so, under what conditions) it ultimately would be in the public interest
to have multiple exchange markets engaged in trading options as a permanent
part of the nation's securities markets." 72/

While the AMEX and PHLX proposals caused the Commission to seek public
comments concerning the appropriateness of permitting the trading of
standardized options with the same underlying security, expiration date,
and exercise price on more than one exchange, 73/ the Commission did

70/ Id.

71/ Id.

72/ Id.

73/ Trading the same options in more than one marketplace will generally
be referred to as "multiple trading." See discussion at 17-18, supra.
This practice has also been referred to as "dual trading." See,
e.g. , Securities Exchange Act Release No. 13325 (March 3, 1977), 11
SEC Docket 1886. (March 15, 1973), and No. 14854 (June 15, 1978),
15 SEC Docket 27 (June 27, 1978).

802

not directly address this issue after public comments were received. 74/
In February, 1976, however, CBOE, with informal Commission approval,
permitted the trading of a class of options that was already being traded
on FHLX. In March of the same year, the Commission, recognizing that
"some of the (call) options that the PSE has proposed to list will be
of the same class and expiration dates and prices as options which are
presently listed on other exchanges," approved a PSE plan to permit
standardized options trading and explicitly found that the PSE proposal
was "consistent with the requirements of the Act and the rules and
regulations thereunder applicable to national securities exchanges,
and in particular the requirements of Section 6 of the Act." 75/

Subsequently, PSE listed and began trading numerous classes of options
that other exchanges had already listed. Other options exchanges also began
to engage in multiple trading. On March 3, 1977, however, PHLX petitioned

74/ See, e^g. , Securities Exchange Act Release No. 10981 (August 22,
1974), 5 SEC Docket 41 (September 3, 1974). Indeed, the AMEX and
PHLX proposals were approved with hardly a mention of multiple
trading. In the order approving the AMEX Plan, the Commission observed
that the AMEX did "not intend initially to undertake the dual trading
of options." Securities Exchange Act Release No. 11144 (December 19,
1974), 5 SEC Docket 734, 738 (December 24, 1974). Similarly, the
Commission noted that PHLX did not "intend initially to undertake
dual trading of options." Securities Exchange Act Release No.
11423 (May 15, 1975), 6 SEC Docket 894, 895 (May 28, 1975).

75/ Securities Exchange Act Release No. 12283 (March 30, 1976),
9 SEC Docket 317, 318, 319 (April 13, 1976).

803

the Commission for '(1) a suspension of all dual trading in options
commenced subsequent to February 1, 1977; (2) a suspension of any dual
trading in options not already started; [or] (3) a requirement of
Commission approval based on showing of cause as to future dual trading." 76/
Responding to the PHLX request, the Commission held a public hearing on
"the existing Commission policy permitting dual trading of options" and
solicited public comments concerning "whether * * * dual trading of
options is in the public interest at this time." 77/

After receiving public comments, the Commission issued a release
stating its view that floor members of the options exchanges who may
have been "increasing substantially their proprietary trading in certain
dually traded options * * * [in order] to induce the purchase or
sale of such dually traded options on their options exchanges instead
of other options exchanges on which the same class is traded" may have
engaged in conduct which violates Section 9 78/ and 10 79/ of the Exchange
Act. 80/ In addition, the Commission "cautioned [brokers] against relying

76/ Letter to Securities and Exchange Commission from Elkins Wetherill
President, PHLX, dated March 3, 1977.

77/ Securities Exchange Act Release No. 13325, supra, n.73.

78/ 15 U.S.C. 78i.

79/ 15 U.S.C. 78j.

80/ Securities Exchange Act Release No. 13433 (April 5, 1977), 11 SEC
Docket 2194 (April 19, 1977).

804

solely on aggregate trading volume reported on [options] exchanges"
when determining the market "to which to route their customers' orders." 81/
To provide better volume data for use in the future as a measure of "the
relative quality of markets/1 the Commission "arrange [d] for publication
of reports obtained from exchanges trading options regarding proprietary
options transactions by floor members." 82/ The Commission did not, however
specifically address the general question of "whether * * * dual trading
of options is in the public interest at this time." 83/

Since the inception of multiple trading of standardized options, 22
classes of call options have been traded on more than one exchange.
At present, however, only 15 classes are multiply traded. Table 1
identifies each of the call option classes that have been multiply traded.
The table also indicates the date that trading began on each exchange and,
where applicable, the date that the class was delisted On any exchange.
It should be noted that no multiple trading of put classes has yet occurred.

81/ Id.

82/ Id. See also Securities Exchange Act Release No. 13448 (April 15,
1977) 12 SEC Docket 18 (May 3, 1977) and No. 13476 (ADril 27, 1977)
12 SEC Docket 190 (May 10, 1977).

83/ Securities Exchange Act Release No. 13325, supra, n.73 at 1886.

805

The NYSE and NASD Plans contemplated an expansion of the multiple

trading of standardized options. 84/ As NYSE has stated:

With specific reference to the NYSE Options Trading
Plan presented to the Commission in June, 1977, * * *
the plan would permit listing and trading of
standardized options on underlying securities that
are traded on the NYSE, whether or not such standardized
options are already listed and traded on other exchanges.
In other words, the NYSE's plan endorses and promotes
dual trading of standardized options * * * . 85/

Multiple trading, in NYSE's view, is mandated by the 1975 Amendments

and should be permitted with respect to all option classes. Thus,

NYSE has stated:

[T]he Securities Acts Amendments of 1975 * * *,
embodying a clear legislative mandate for maximum
competition among orders, among market centers
and among market-makers, implicitly preclude
the alternative of arbitrarily restricting trading
in any security to any single market center. The
powerful pro-competitive bias that permeates the
1975 Amendments offers no basis for insulating
options trading from competition. Thus, dual trading
should not only be permitted in some classes of
options and among some market centers, as it is
today, but it should be permitted in all classes
of standardized options and among all market centers —

84/ The NASD Plan contemplated an expansion of multiple trading in
standardized options to the over-the-counter markets. Analysis
of such a proposal may require consideration of many of the factors
discussed in this section. Additional factors that should be
considered when evaluating proposals to expand multiple trading
into the over-the-counter markets are discussed in Section V,
infra.

85/ Letter to George A. Fitzsimmons, Secretary, Securities and Exchange
Commission, from James E. Buck, Secretary, NYSE, dated September 22,
1978 at 5 ("NYSE Letter"). A copy of this letter is provided as
Appendix Exhibit 1.

806

subject, of course, to appropriate regulations and
surveillance. 86/

CBOE, on the other hand, has contended:

' While we believe that there should be enhanced
competition among exchanges in the trading of
options and that, in a proper national market
system framework, this may take the form of
multiple trading, further expansion of multiple
trading should not be permitted unless and until
a national market system for options, and the
resulting creation of a fair field of market
competition, have been substantially achieved.
In the absence of the latter, expanded multiple
trading would inevitably result in (1) further
undesirable fragmentation of the market, and,
at times, disorderliness and confusion; (2)
problems of best execution * * * and (3) a gradual
decline in effective competition because of
the absence of a fair field of competition. 87/

PHLX 88/ and PSE 89/ view the multiple trading question in generally

the same light as CBOE. 90/

86/ Id., at 2.

87/ Letter to George A. Fitzsimmons, Secretary, Securities and Exchange
Commission, from Joseph W. Sullivan, President, CBOE, dated
September 22, 1978, at 1 ("CBOE Letter"). A copy of this letter
is contained in Appendix Exhibit 2.

88/ Letter to George A. Fitzsimmons, Secretary, Securities and Exchange

Commission, from Elkins Wetherill, President, PHLX, dated September 25,
1978, at 1-10 ("PHLX Letter"). A copy of this letter is contained in
Appendix Exhibit 3.

89/ Letter to George A. Fitzsimmons, Secretary, Securities and Exchange

Commission, from Charles J. Henry, President, PSE, dated September 22,
1978, at 5-7 ("PSE Letter"). A copy of this letter is contained in
Appendix Exhibit 4.

90/ AMEX and MSE have not recently expressed views on the broad issue of

whether multiple trading of standardized options is appropriate or should

(footnote continued on next page)

807

This section will discuss the factors that the Commission should
consider when determining whether, and under what circumstances, multiple
trading of standardized options should be permitted to expand. It will
(i) discuss the effects that multiple trading may have had on the markets
for standardized options that have been multiply traded, (ii) describe
the fragmentation of the markets for standardized options that has resulted
from multiple trading, and (iii) provide a framework within which proposals
to expand multiple trading of standardized options may be evaluated.

A. The Effects of Multiple Trading of Standardized Options

In their responses to the Commission's request in March, 1977 for public
comments concerning multiple trading, both CBOE and AMEX were of the view

(footnote continued)

be allowed to expand. AMEX has addressed the multiple trading question
solely in the context of multiple trading involving NYSE and the options
exchanges, and MSE has not indicated any views with respect to
any of the issues presented in Securities Exchange Act Release No.
14854, supra, n.73. With regard to AMEX views on multiple trading
involving NYSE, see Letter to George A. Fitzsimmons, Secretary, Securities
and Exchange Commission, from Robert J. Birnbaum, President, AMEX, dated
September 29, 1978, at 5 ("AMEX Letter"). A copy of this letter is
included as Appendix Exhibit 5. NASD has expressed views with respect
to multiple trading only insofar as exchange-listed options may be
traded in the over-the-counter markets. See Letter to George A.
Fitzsimmons, Secretary, Securities and Exchange Commission, from
Gordon S. Macklin, President, NASD, dated September 22, 1978 at 6-7
( "NASD Letter" ) . A copy of this letter is included as Appendix
Exhibit 6.

808

that multiple trading provided significant benefits to the investing public

CBOE, for example, stated:

Experience in multiple trading in options to
date has shown that, largely in response to forces
of competition, markets have improved and costs
have been reduced on the exchanges that have been
engaged in this competition, Although these
benefits are concentrated in the option classes
that have been the subject of dual trading, in
many cases they have also carried over to classes
of options that are not dually traded. Market
improvements are reflected in narrower bid/ask
spreads, better price continuity between
consecutive transactions and greater depth and
liquidity. Cost savings have resulted from,
among other things, reductions in charges by
CBOE board brokers and AMEX specialists, and
reductions in floor brokerage. 91/

Similarly, AMEX stated its belief "that dual trading can provide positive

benefits to the public in terms of more effective markets, lower execution

costs and improved services." 92/

In October, 1978, however, CBOE concluded that its statement that

multiple trading had "improved" the markets "was not well-founded, both

because (1) we did not sufficiently take into account other variables

(apart from dual trading itself) that can affect comparisons of bid/ask

91/ Letter to Sheldon Rapoaport, Division of Market Regulation, Securities
and Exchange Commission, from Joseph W. Sullivan, President, CBOE,
dated March 15, 1977, at 1-2.

92/ Statement of the American Stock Exchange, Inc. in response to

Securities and Exchange Commission Release No. 13325 (March 17, 1977),
at 2.

809

spreads and successive prices, and (2) later experience has shown that
improvements in these respects in the first few months after the commence-
ment of dual trading have not generally been sustained over longer periods
of time." 93/ This section will examine the effects that multiple trading
has had (i) on the quality of the markets for options that have been multiply
traded, and (ii) in fostering competition among options exchanges.

1. The Effects of Multiple Trading on the Quality
of Markets for Multiply Traded Option Classes

'•Continuity" and "liquidity" are among "the most conspicuous ingredi-
ents" of orderly securities markets. 94/ These concepts are frequently
used to evaluate the quality of these markets. A "continuous" market is one in
which "a series of consecutive separate transactions, even though involving
price changes, will involve minimum price variations or deviations." 95/
A "liquid" market is one in which "a willing seller can readily (or perhaps
immediately) find a buyer, or vice versa, at a mutually agreeable price." 96/
'Depth," another term that is often used to describe and measure the quality

93/ Letter to Richard I. Weingarten, Special Counsel, Special Study of
the Options Markets, from Joseph W. Sullivan, President, CBOE,
dated October 11, 1978. A copy of this letter is provided in
Appendix Exhibit 7.

94/ Special Study, supra, n.63, at 15.

95/ Id., at 16 (footnote omitted).

96/ Id.

810

of a market, has been referred to as "the quantity of buying and selling
interest and the potential activity on each side of the market." 97/

In an effort to evaluate the effects of multiple trading on option
classes that were traded on more than one exchange, the Options Study
obtained data from each of the options exchanges concerning the liquidity,
continuity, and depth of the market for each multiply traded class for
each week for the three months before and the three months after
the initiation of multiple trading. 98/ More specifically, the Options
Study sought to measure liquidity for each multiply traded class by
gathering data concerning the average difference between the bid and
ask price ("bid/ask spread") during the before and after period. Price
continuity was tested by obtaining data regarding the average variation
in price between transactions and the contract volume for each such
class during the six month study period.

Table 2 compares price continuity data on the exchange that first
listed an option class for the three months before and after the initiation
of multiple trading. The table includes only those option classes that

97/ Id., at 17.

98/ See, e.g., Letter to Joseph W. Sullivan, President, CBOE, from

Richard Weingarten, Special Counsel, Special Study of the Options
Markets, dated July 10, 1978. A copy of this letter is contained
as the last document in Appendix Exhibit 7.

811

CBOE and AMEX multiply trade. The data reveal that, after multiple
trading began, price continuity improved significantly on the exchange
that had initiated trading in the multiply traded class. In fact, the
average variation in price between transactions on the exchange that
initiated listing declined by approximately 20 per cent during the periods
studied.

Similarly, bid/ask spreads improved on the exchange that had initiated
trading in a multiply traded class after multiple trading began between
CBOE and AMEX. Table 3, for example, contains data comparing the average
bid/ask spread on CBOE or AMEX, depending upon which exchange commenced
trading in an option class, for the three months before and after
the initiation of trading on both exchanges. The data indicate that
the average bid/ask spread improved on the exchange that listed the
multiply traded class initially by approximately 34 per cent. In addition,
Table 4 indicates that total contract volume was substantially larger
during the three months following the initiation of multiple trading
on CBOE and AMEX than it had been previously. This increase in total
volume may have contributed to improvements in price continuity and
bid/ask spreads on both exchanges, even though the volume of each
exchange was generally less than the volume on the exchange that had
traded the class prior to the initiation of multiple trading.

Tables 5 and 6 show similar patterns when multiple trading occurred
between CBOE or AMEX and PHLX, PSE, or MSE. Price continuity improved

812

on the exchange that initially listed the option class by an average

of 14.8 per cent, and bid/ask spreads improved by an average of 13.6 per cent.

Although these data indicate that the quality of the markets for

standardized options generally improved after the initiation of multiple

trading, they may not be sufficient to support broad conclusions with

respect to the causal relationship, if any, between the improvement

in market quality and multiple trading. CBOE, for example, recognized

the role that factors other than multiple trading may have played during

the study period and prepared an analysis of the impact of multiple

trading on market quality during the three months before and after CBOE

began to engage in multiple trading. 99/ With respect to the impact

that other factors may have upon price continuity and bid/ask spread

data, the CBOE Study stated:

A principal conclusion * * * which warrants
emphasis at the outset is that changes in price
continuity or bid/ask spreads on a given exchange
between periods before and after dual listing can
result from factors which have nothing to do with
dual listing, such as changes in the price level of
underlying stocks, changes in the mix of striking
prices of outstanding option series and the occurrence
of option expirations.

99/ See attachments to Letter to Richard I. Weingarten, Special Counsel,
Special Study of the Options Markets, from Joseph W. Sullivan,
President, CBOE, dated October 11, 1978, at 2 ("CBOE Study"). A
copy of the CBOE Study is contained in Appendix Exhibit 7.

813

To illustrate how such factors may affect quality
of markets measures in different time periods, a
drop in the price of an underlying stock from one period
to another would be expected, other things equal, to
result in a decrease -in the average price change from
last trade or in the average bid/ask spread of an
option class, as option prices decline in response to
the decline in the price of the underlying stock. In
addition, chanaes in the availability of option series
with various striking prices may affect measures of
quality of markets between two periods. For example,
during one period, if an underlying stock trades in a
narrow range of 61-64, with only 50 and 60 option
series available, both series would be in-the-money.
If during a second period, the stock trades in the
slightly broader range of 61-65, the 70 series would
be introduced. When quality of markets measures for
the two periods are compared, the average price
change from the last trade and average bid/ask spreads
could both be lower in the second period simply
because an out-of-the-money series had been available,
as compared with only in-the-money series in the first
period. Mo r ever , the occurrence of an option expiration
can affect quality of market comparisons. For example,
the erosion in time value of expiring series as
exoiration approaches may tend to reduce average price
changes and bid/ask spreads in comparison with a
period immediately after expiration, when expired series
have been replaced with new nine month options which
have a high time value. 100/

In view of these considerations, CBOE concluded with respect to the

quality of its markets immediately before and after the initiation of

multiple trading:

[W]hen factors which affect quality of markets
measures independently of dual listing are considered,
dual listing did not materially affect price continuity

100/ Id., at 3-4.

40-940 O - 79 - 54

814

or size of bid/ask spreads on the exchange on which
option classes had been exclusively listed * * *. 101/

While the Options Study does not disagree with the method of CBOE's

analysis, a closer look at the quality of markets for DuPont de Nemours

and Company ("DuPont") and Merrill Lynch Corporation ("Merrill Lynch")

calls immediately before and after CBOE and AMEX initiated the multiple

trading of these classes offers some additional insights. DuPont

calls, for example, were traded exclusively on AMEX prior to the initiation

of multiple trading. The CBOE Study did not consider this class in its

analysis of classes initially listed on AMEX. 102/ Table 7A, however,

contains price continuity data for DuPont options on AMEX for the three

months prior to and following the initiation of multiple trading, and

Table 7B contains, for comparison purposes, CBOE price continuity data

after dual trading had begun. 103/ Table 7A also indicates high and low

101/ Id., at 7-8.

102/ The CBOE Study analyzed the quality of markets before and after

the commencement of multiple trading for only two of the five classes
that AMEX initially listed and that are multiply traded with CBOE.
These classes, Disney Productions and Merrill Lynch, were selected
"at random." See CBOE Study, supra, n.99, at 2-3, 12-19.

103/ While CBOE data are provided for the purposes of comparison,
these data are at best only generally comparable because CBOE
and AMEX derive price continuity data differently and bid/ask

(footnote continued on next page)

815

stock prices during each week of the study period, the weeks during
which expirations occurred, and the series that were traded each
week. Table 8A shows bid/ask spread data for Dupont options on AMEX

(footnote continued)

data may reflect the different marketmaking systems of these
exchanges. As AMEX has stated:

It is necessary to comment on the statistics on dual
trading in options that are being issued by the CBOE
since these statistics have been published without an
explanation of some important differences in the reporting
systems employed by each exchange, and may be used by
firms in making important decisions on order flow.

Continuity

Liquidity statistics as furnished by CBOE are, in
most instances, not comparable [to those furnished
by AMEX] , because of important differences in the
systems each exchange utilizes to report trades on the
options transaction reporting] tape. In particular,
CBOE data * * * neglects to differentiate the following:

Where a buyer purchases options from four different
sellers at the same price in one trade, the Amex
would report one transaction while the CBOE would
report four transactions, all at the same price.
This difference in reporting methods unreal istically
raises the number of CBOE transactions reported at
"no change" .

On the CBOE, if the buyer of 20 options enters into a
transaction and the price is up 1/8 from the last sale,
and there are four sellers on the other side, the trans-
actions will be reoorted as one trade for five contracts
up 1/8 and three additional trades "unchanged". On the
Amex, the transaction would be reported as one trade of
20 contracts, up 1/8. * * *.

(footnote continued on next Dage)

816

before and after the initiation of multiple trading, and Table 83
contains similar data for CBOE for the period after multiple trading
had begun.

Significantly, Table 7A demonstrates that Oupont stock was trading
within substantially the same price range before and after the initiation
of multiple trading: the stock traded between $121 1/2 and $139 3/4
before multiple trading and between $123 and $134 5/8 after. In addition,
the table shows that the mix of in- and out-of-the-money series remained
relatively constant throughout the study period, even though two expirations
took place. Hence, Dupont presents a situation in which the influence of
factors other than multiple trading on the quality of market data should be
minimal.

(footnote continued)

Trades

In addition, CBOE statistics provide the number of trades
for each dually traded option class. These figures, too, are
subject to the different methods of reporting outlined above
and to the extent that they report one transaction as multiple
trades, tend to inflate the number of CBOE trades.

Memorandum to Members, Member Organizations and Registered Options
Principals, from Robert J. Birnbaum, Executive Vice President,
AMEX, dated March 7, 1977.

817

Under these circumstances, the quality of the AMEX market for
DuPont options improved considerably after the initiation of multiple
trading. The average variation in price per transaction was reduced by
approximately 20 per cent, and the average bid/ask spread narrowed by
approximately the same amount. Moreover, a comparison of the four weeks
immediately following the January expiration and the four weeks immediately
following the April expiration, during which time the stock was trading
in a similar range and the mix of in- and out-of-the-money series was
essentially the same, reveals an improvement of approximately 19 per
cent in price continuity and of nearly 18 per cent in the bid/ask spread.
It should also be noted that these improvements in market quality occurred
even though the average number of contracts per transaction increased
on the AMEX by 49 per cent after multiple trading began. 104/ Most dramati-
cally, in the three weeks immediately following the initiation of multiple
trading, a 31 per cent improvement in price continuity and a 27 per cent
improvement in the bid/ask spread took place on AMEX despite the facts
that (i) a new series of far term, in-the-money, options was introduced, and
(ii) there was a increase of approximately 140 per cent in the average

104/ A substantial increase in the number of contracts per transaction may
result in wider variations in price between transactions and wider
bid/ask spreads, because the risk associated with each transaction
may be greater.

818

number of contracts per transaction. Both of these factors would normally

be expected to result in a worsening of market quality indicators. 105/

Tables 9 and 10 contain data with respect to the quality of markets

for Merrill Lynch options on AMEX prior to and following, and on CBOE following,

the initiation of multiple trading. Again, stock prices during the study

period, expiration weeks, and the mix of in- and out-of-the-money series

are shown. CBOE, in its analysis of Merrill Lynch option activity,

stated :

[T]he quality of markets in Merrill Lynch on the
Amex changed rather markedly between the month of
January and the three months following dual listing.
For example, the average price change between trans-
actions fell from 3.5 cents in January to 2.3 cents
in the after period while average bid/ask spreads
dropped from 14.1 cents to 11.2 cents. * * *

[T]he change in quality of markets after dual
listing appeared to result from a sharp drop in
the price of the underlying stock. During January,
the underlying stock's monthly mid-range was 23-7/8;
after dual listing its weekly mid-range declined
almost continuously from 19-1/2 to 17-1/2. The
difference in underlying stock price levels in the
two periods resulted in substantial differences in
Merrill Lynch option prices. For example, on the
Amex, the average Friday closing price of all
Merrill Lynch option series was $1.72 a week before
the January expiration, compared with $0.58 a week
before and $1.15 two weeks after the April expiration. 106/

105/ See n.100, and accompanying text, supra, and n.104, supra.
106/ CBOE Study, supra, n.99, at 16-18 (footnote omitted).

819

While CBOE may have appropriately analyzed the period from January
through the end of the study period, the six weeks immediately following
the initiation of multiple trading deserve closer consideration, ^om
the January expiration to the April expiration, no changes occurred
in the series that were being traded. Moreover, while the stock was
consistently declining in price in the weeks prior to the beginning
of multiple trading, neither this decline nor the diminishing time value
of the options series between January and April seems sufficient to
explain the improvements in market quality on AMEX that occurred at
the same time as CBOE initiated multiple trading. Specifically, even
though the stock price was declining consistently during December, January,
and February, AMEX quality of market indicators did not vary significantly
during that period. For the four weeks after the January expiration
week, for example, the average variation in price between transactions
on AMEX was 2.9C with the stock trading between $19 7/8 and $23 7/8.
In the six weeks immediately after the initiation of multiple trading,
however, the stock traded between $18 and $20 5/8 but the average variation
in price between transactions was only 1.85C. Most dramatically, during
the week before the initiation of multiple trading, Merrill Lynch stock
traded between $19 7/8 and $21 3/8 and the average variation in price
between AMEX transactions was 3.1C, and during the week after multiple
trading began the stock traded between $18 1/2 and $20 1/2 and the average
AMEX variation in price was 2.1C, a 32 per cent improvement. In addition,

820

it should be noted that the average bid/ask spreads on AMEX for the
four weeks after the January expiration was 12. 8C, but was 8.9C for
the six weeks after the initiation of multiple trading, and" improved
more than 17 per cent, from 11. 5C to 9.5C, between the week before and
the week after multiple trading began. As with DuPont, these improve-
ments occurred even though the average number of contracts per transaction
on AMEX increased from 9.7 to 13.3, a 37 per cent increase, between
the January and April expirations.

Supplemental data that AMEX submitted showed similar improvements
in the quality of the markets for two more of the five classes that
AMEX initially listed and CBOE and AMEX multiply trade. 107/ The AMEX
data summarized price continuity and bid/ask spreads for multiply traded
options in various price categories. AMEX organized its data in this
fashion so that changes in price continuity and bid/ask spreads for
options with similar premiums could be compared before and after the
initiation of multiple trading. Since option premiums reflect, among
other things, (i) price movements in the underlying stock, and (ii)
the mix of in- and out-of-the-money series available at a particular
time, many of the difficulties associated with evaluating continuity
and spread data for a class of options over a period of time may be
reduced. 108/

107/ See n.102, supra.

108/ See discussion at 34-40, supra.

821

Table 11A supports the previous conclusions that have been drawn
with respect to improvements in the quality of AMEX markets for DuPont
options after the initiation of multiple tradinq. The table contains
summary price continuity and bid/ask spread information, organized by
option premium size, for DuPont calls. The data indicate that the average
variation in price between transactions in DuPont calls was lower in
the three months following the initiation of multiple trading in every
option premium range but one. 109/ In the DuPont calls whose premiums
ranged from $8 - $9 7/8 and from $10 - $14 7/8, for example, the average
variation between transactions was reduced by 35 per cent and 37 per cent
respectively. Similarly, the DuPont calls with premiums ranging from
$6 - $7 7/8, $8 - $9 7/8, $10 - $14 7/8 and $15 - $19 7/8 all showed
15 per cent or more reductions in average bid/ask spreads in the three
months after the initiation of multiple trading.

Tables 11B and 11C evidence similar improvements in Burroughs
Corporation ("Burroughs") and Digital Equipment Corporation ("Digital")
options. These tables show that price continuity in both Burroughs

109/ It should be kept in mind that the relevant comparison of data when price
continuity and bid/ask spread information is presented by premium is
between options trading within the same premium range in the before
and after period. With respect to Table 11A for instance, the 2.3C
average variation in price of DuPont calls trading at premiums under
7/16 in the before period is most appropriately compared to the 2.0C
average variation in the after period for similarly priced options.

822

and Digital calls consistently improved after the initiation of multiple
trading. 110/ Moreover, bid/ask spreads were significantly reduced at
each premium range for both Burroughs and Digital. In fact, Table 11B
shows that in all but three premium ranges, average bid/ask spreads
for Burroughs calls were reduced by 15 per cent or more in the three
months following multiple trading. More dramatically, for Digital options
in all premium ranges above $1/2 - $15/16, bid/ask spreads improved
by 20 per cent or more after the initiation of multiple trading.

Although these data are limited and have not been subjected to
complete regression analysis, they suggest that multiple trading between
AMEX and CBOE may improve the quality of markets for an option class
that is multiply traded in the short run. These data, however, do not
provide sufficient information to permit conclusions concerning what
the effects of multiple trading may be on the quality of markets for
standardized options over the longer term. In particular, movements
in the price of an underlying stock, expirations of option series, the
addition of new series, and changes in the mix of exercise prices of out-
standing series may contribute to changes in price continuity, bid/ask spreads
and contract volume for a multiply traded option class. Further, improvements
in market quality during the three month period immediately following the

110/ While Digital calls with premiums ranging from $10 - $14 7/8 showed
significantly higher variations between transactions in the post-
multiple trading period, this result may be explained by the fact
that fewer transactions were executed at those premium levels
in the three months after multiple trading. See, e.g. , Burroughs
data in Table 11B concerning price continuity and number of
transactions for similarly priced options.

823

initiation of multiple trading may not be sustained over a longer period
of time because marketmakers seeking to attract order flow and establish
their market as the primary market 111/ may allocate more capital and
assume greater risks during the first weeks of multiple trading than
under normal conditions. 112/ Moreover, general market conditions
may change significantly over time and make it difficult, if not impossible,
to isolate the effects of multiple trading from the effects of these
other factors.

With respect to option classes that were multiply traded between
CBOE or AMEX and PHLX, PSE, or MSE during the six month study period,
the data did not suggest conclusions different from those stated above.
Over the long term, however, PHLX, PSE, and MSE have not been able to
attract sufficient order flow to provide markets that would be competitive
with those that CBOE and AMEX provide. As Table 1 indicates, PHLX, PSE,
and MSE have voluntarily delisted 6 of the 13 option classes that these
exchanges multiply traded with CBOE or AMEX. In addition, Table 12
demonstrates the extremely limited order flow that these exchanges

111/ The "primary market" is generally "the market which has the greatest
trading volume" in a particular security. Special Study, supra ,
n.63, at 12. Other market centers will be referred to as " secondary'
markets or exchanges in this chapter. The significance of a primary
market designation is discussed at 52-61, infra.

112/ It should be noted that options marketmakers may have increased
their proprietary trading during the first few weeks of multiple
trading for the purpose of inducing others to send options orders
to the exchange on which these marketmakers were making markets.
The Options Study has not attempted to determine what effect, if
any, such trading may have had upon the data discussed above. See
Securities Exchange Act Release No. 13433, supra, n.80.

824

have been able to attract when competing with CBOE or AMEX.

2. Competition Among Market Centers

Quality of market indicators are not the only measure of the effect
of multiple trading upon the markets for options that have been traded on more
than one exchange. Indeed, it should be kept in mind that multiple trading
provides the public with a choice regarding where to send an order for
execution. As a result, multiple trading is the foundation for competition
among market centers and provides competing market centers with "the impetus
for greater operational efficiencies, improved services and new technological
developments." 113/ Moreover, multiple trading is the exclusive means by
which marketmakers at various market centers can compete with each other for
orders for a security. In fact, competition "among brokers and dealers,
among exchange markets, and between exchange markets and markets other than
exchange markets" 114/ could occur only under extremely limited circumstances
if multiple trading were not permitted.

The competition among market centers that multiple trading of stand-
ardized options has caused may be seen in numerous areas. CBOE board

113/ Statement of the American Stock Exchange, Inc., supra, n.92, at 2.
See also, e.g., Special Study, supra, n.63, at 903-906 and 937-942.

114/ Section llA(a)(l) (C) (ii) of the Exchange Act [15 U.S.C. 78k-l(a) (1)] .

825

brokers and AMEX specialists, for example, have occasionally reduced
their brokerage charges in an effort to attract more option orders. 115/
Reductions in the rates that independent floor brokers on these exchanges
charge their customers have occurred for the same reason. 116/ In addition,
CDOE and AMEX have begun to develop automated order routing systems
and methods of protecting public limit orders with a view toward reducing
the costs of executing orders on their exchanges, obtaining more rapid
execution of public orders, and assuring better protection of limit
orders. Among the considerations involved in making the decision to
develop and implement these innovations was the clearly perceived need
to attract a substantial portion of public orders in multiply traded
options. 117/ Similarly, NYSE has stated that, in addition to offering
"competitive execution prices," it will offer other services "to make
it worthwhile for brokerage firms to send their [option] orders to the
NYSE market "if permitted to engage in multiple trading." 118/ NYSE stated:

115/ Letter to Sheldon Rappaport from Joseph W. Sullivan, supra,
n.91, at 2.

116/ Id.

117/ See, e.g., CBOE, OSS Report, dated March 22, 1978, at Section II, 1-4.

118/ NYSE Letter, supra, n.85, at 3.

826

First, the NYSE believes that using an order book
official, who is an Exchange employee, to represent
the orders on the limit order book, will lead to
cost-effective service.

Second , the NYSE is developing an automated 1 imit
order book for options that should reduce much of
the human- intensive paper handling that is so costly
to firms. The ability to transfer "away-from-the-
market" orders directly from the firm's computer
into the automated book, coupled with an automated
delivery system for executable orders, should be
attractive to firms handling options orders. * * *

[Third,] the NYSE is also looking into other possible
computer -supported services which might be introduced
to enhance the effectiveness of an NYSE options
market at some time after it has gained essential
experience in trading standardized options. 119/

NYSE also suggested that it may be able to offer "substantial efficiencies

that would result from a firm's ability to route customers' combined

stock/option orders to a single market center * * * ." 120/

Multiple trading has also caused CBOE to improve certain aspects

of its floor operations. During the high volume period from April 14-21,

1978, CBOE had "difficulties" matching the parties and terms of trades

that occurred on its floor. 121/ At least partially as a result, a number

of brokerage firms determined to send their retail orders for option

119/ Id., at 3-4, 10.

120/ Id., at 9.

121/ Letter to Andrew M. Klein, Director, Division of Market Regulation,
from Joseph W. Sullivan, President, CBOE, dated June 16, 1978, at 6.

827

classes that were also traded on AMEX to that exchange. One of these

firms explained:

In terms of what happens to the order subsequent
to execution, we believe, * * * that the performance
of the AMEX during the recent periods of extraordinary
volume, was superior to that of the CBOE. 122/

Subsequently, CBOE, faced with the possibility of losing a substantial

portion of its order flow in multiply trading options, "undertook a

number of steps intended to strengthen its capacity to handle trade

matching at high volume expiration periods" and "to improve the trade

comparison process." 123/

B. Market Fragmentation

"Market fragmentation" is the dispersion of trading activity for
a multiply traded security among numerous market centers. When markets
are fragmented, it may be difficult for brokerage firms to discover
and obtain the most favorable price for their customers. Firms need
to monitor and obtain rapid access to more than one market center and,
due to the limitations on the ability to obtain and react to market
information instantaneously, may not be able to execute orders at the

122/ Letter to Roberta S. Karmel, Commissioner, Securities and Exchange
Commission, from Wallace 0. Sellers, Vice President, Merrill Lynch
& Co. Inc., dated June 13, 1978.

123/ Letter to Andrew M. Klein from Joseph W. Sullivan, supra , n.121,
at 8.

828

best available prices even if monitoring the markets continuously. In
addition, prices in the various markets may not reflect a complete assess-
ment of current value by all buying and selling interests since orders
sent to or present at different market centers may not have an opportunity
to interact. In view of these two factors, certain kinds of orders,
particularly orders of retail customers, may not be executed at the most
favorable prices obtainable. 124/

This section will discuss the extent of market fragmentation for multiply
traded option classes. It will then describe the methods that brokerage
firms use to route orders to and among markets for these multiply traded
classes in pursuit of the most favorable execution opportunities. Finally,
the impact of multiple trading on the pricing of classes traded on more
than one exchange will be examined.

1. The Extent of Market Fragmentation For Multiply
Traded Option Classes

Table 12 indicates the percentage of contract volume that each options

exchange attracted in each class traded on C30E or AMEX and on a secondary

exchange on selected days between February 24, 1977 and August 31, 1977.

Table 13 indicates the percentage of contract volume that CBOE and AMEX

attracted in each class that was multiply traded on these exchanges

exclusively during the same period. The data that these tables contain

124/ See generally, with respect to the problems of market fragmentation,
Securities Exchange Act Release No. 13662 (June 23, 1977), 12 SEC
Docket 947, 958-964 (July 5, 1977).

829

reveal that CBOE and AMEX divided contract volume approximately evenly
in three of the nine classes that were traded on both exchanges. 125/ In
five other such classes, the exchange that was not primary was still able
to attract consistently more than 25 per cent of the total volume. 126/
With respect to classes that were traded on AMEX or CBOE and a secondary
exchange, however, Table 12 clearly shows that the secondary exchanges
were not able to attract significant volume in classes that are multiply
traded with AMEX or CBOE. Moreover, Table 14 demonstrates the small
percentage of total volume that the secondary exchanges are able to
attract in all option classes. This table identifies the percentage
of total volume for all multiply traded classes that each options exchange
maintained during the February through August, 1977 period and shows
that CBOE and AMEX maintained 71.05 per cent and 26.13 per cent respectively
of the total volume while the PSE, PHLX, and MSE maintained 1.53 per
cent, 1.04 per cent, and .35 per cent respectively.

More recently, contract volume continues to be dispersed between
CBOE and AMEX for classes traded on both of these exchanges. Table 15
provides data with respect to the percentage of total contract volume that

125/ Burroughs Corporation, DuPont, and Digital.

126/ Bally Manufacturing Corporation, Disney Productions, Merrill Lynch,
MGIC Investment Corporation and Tandy Corporation.

40-940 O - 79 - 55

830

these exchanges maintained during August, 1978 for each of the ten classes
that they both traded at that time. In eight of the ten classes, the
secondary exchange was able to attract more than 15 per cent of the total
volume, 127/ and, in four of the ten classes, the secondary exchange
captured more than 30 per cent of that volume. 128/ PHLX and PSE, on
the other hand, have delisted many of the classes that they once multiply
traded 129/ and attracted virtually no volume during August, 1978 in
the classes that they multiply traded with CBOE or AMEX. 130/ Accordingly,
significant market fragmentation continues to exist for option classes
traded on both CBOE and AMEX.

2. Brokerage Firm Order Routing Decisions in the Fragmented
Market Environment

When there are multiple markets for the same security, market participants

must decide to which market they will send their orders to buy or sell that

security. As agents for their customers, brokers have an obligation to

execute their customers' orders at the best price available under the

127/ American Express, Bally Manufacturing Corporation, Digital,

Disney Productions, DuPont, Merrill Lynch, MGIC Investment Coporation,
and National Semiconductor Corporation.

128/ American Express, Bally Manufacturing Corporation, Digital, and
National SemiCondutor Corporation.

129/ See Table 1.

130/ The average contract volume for August, 1978 on the secondary exchanges
for the seven classes they multiply traded with CBOE or AMEX was
95 contracts, which was less than .01 per cent of the total volume
in those classes.

831

circumstances. 131/ As a result, brokerage firms have developed numerous
methods of determining where to send orders for options traded on more
than one exchange.

Most firms handling substantial numbers of public orders in multiply
traded options have designed automated systems to transmit customer orders
for such options to the exchange that the firm has designated as "primary.1
Although the bases that these large retail firms use for designating an
exchange as "primary" vary from firm to firm, a principal factor that the
firms consider is the volume of public orders that are executed on each
exchange. Firms also consider, albeit to a lesser extent, (i) the experi-
ence of their traders with respect to the quality of the competing
markets in terms of price continuity, bid/ask spreads, and depth, (ii) the
speed with which executions can be obtained at each market center, and
(iii) the operational efficiency of each exchange. Once an exchange is
designated as primary, the firms generally review their designation
only if they receive numerous complaints from customers about the
quality of executions, volume on that exchange declines appreciably,
or an unusual operational problem or market occurrence compels a
reexamination of the designation.

131/ See, e^. Arleen W. Hughes, 27 S.E.C. 629, 636 (1948), aff'd.
1974 F2d 966 (D.C. Cir., 1949); Wolfson, Phillips and Russo,
Brokers, Dealers and Securities Markets, Section 2.09 (1977);
and SEC, Policy Statement of the Securities and Exchange
Commission on the Structure of a Central Market System,
p. 46-47 (1973).

832

Not all customer orders, however, are automatically sent to the
exchange that has been designated as primary. Institutional orders, for
instance, are normally given "special handling." This involves sending
the orders to the firm's upstairs trading desk and checking, usually by
making a telephone inquiry to the trading floors, the quality of the market
on each exchange on which the option is traded. Large orders from other
customers may receive similar treatment. 132/ In addition, firms generally
permit customers to specifically indicate the market to which an order
should be sent, and some firms permit their registered representatives
to exercise discretion and route customer orders to the market that has
not been designated as primary if transaction and quotation information
available to the registered representative indicates that the nonprimary
market is clearly superior to the primary market at the time that the
customer order is to be transmitted for execution. However, firms do not
routinely explain the customer's right and ability to choose the market
to which his order will be sent, and, perhaps as a result, customers
seldom exercise this right. Moreover, some firms do not permit their
registered representatives any discretion with regard to routing customer

132/ One large retail firm indicated that it permits its registered

representatives discretion to designate any customer order for more
than 10 contracts for special handling. Another such firm indicated
that it instructs its registered representatives to direct all
customer orders for more than 25 contracts to its upstairs trading
desk. A third such firm automatically sends all agency orders for
more than 100 contracts to its upstairs trading desk and allows its
registered representatives discretion to designate orders of more
than 50 but less than 100 contracts for special handling.

833

orders, and those that allow some discretion may actively discourage

the use of such authority. By contrast, orders for a firm's own account

are always given special handling. 133/

A decision by a major retail firm to designate one market or another

as "primary" may have significant ramifications for market centers and

marketmakers competing to attract orders for a multiply traded option.

In this regard, the PHLX experience with the multiple trading of Boise

Cascade options is instructive:

Prior to the institution of dual trading, on
February 9, 1976, PHLX operated a deep and liquid
market in Boise Cascade which attracted substantial
public order flow. Then CBOE began to trade those
options. Within three months, CBOE had become the
primary market and Boise Cascade activity at PHLX
had become sporadic and insignificant. * * * The
mechanisms by which this transformation took place
are neither secret nor complex. * * * The high
volume brokers whose orders were critical to the
maintenance of a major market did not, by and
large, consider it practical to make an individual
decision with respect to each order. They dealt
with one exchange or the other, and the choice
of exchange depended on two factors: (1) whether
one exchange seemed to have significantly more
activity than the other; and (2) which exchange
seemed more convenient in view of the communications
facilities and personnel which the broker had already
committed to the exchange for purposes of dealing
in other options. When dual trading started, the

133/ Of course, the number of proprietary and special handling orders
executed daily may be a relatively small percentage of the total
number of orders automatically routed by a brokerage firm with a
substantial retail business. For example, one major retail firm
indicated that, on a typical trading day, its trading desk executed
50 proprietary and 190 agency special handling orders out of approxi-
mately 3,200 orders.

834

exchanges' volume appeared to have rough parity
with each other . Once the convenience factor
began to draw brokers into the CBOE sphere of
influence, and was augmented by the size of the
market factor, the movement from a sole market
in PHLX to a virtually sole market at CBOE
became inevitable. 134/

From this experience, PHLX concluded:

Dual trading in the current option environment,
then, is in reality simply the transfer of an
options market from the smaller exchange to the
larger, with only a brief period of activity that
could be regarded as competitive in any sense.
Long range competition will be possible only if
natural public trading in an option should reach
a level which would support multiple markets,
or if a composite market can be developed by the
electronic linking of option markets. 135/

The multiple trading experience of PSE was similar to that of PHLX.

PSE concluded "that, because of established patterns of order flow and

because of the procedures many large retail houses use in designating

markets, dual trading has not succeeded in introducing meaningful competition

between marketmakers on our exchange and marketmakers on the older options

exchanges * * * ." 136/ Summarizing its multiple trading experience,

PSE stated:

134/ Statement of the Philadelphia Stock Exchange, Inc., in response
to Securities Exchange Act Release No. 13325, supra, n.73, dated
March 17, 1977, at 2.

135/ Id., at 3.

136/ Statement of the Pacific Stock Exchange, Inc. in response to Securities
Exchange Act Release No. 13325, supra, n.73, dated March 17, 1977, at 1.

835

Where PSE has begun trading classes of options
previously traded on CBOE or AMEX, the share of total
volume that PSE has been able to attract has generally
been quite low. Where PSE has begun trading a new
class of options simultaneously with CBOE (Houston
Oil and Minerals and Bank of America) it has seen a
fairly large share of the volume for the first few
weeks of dual trading (ranging from approximately
35% to 65%), with its share of volume decreasing
after the first few weeks as firms increasingly
designated the other exchange. 137/

In conclusion, PSE stated:

We do not believe our lack of success with dual
trading can be attributed to any failings of our
market makers or to any failure on the part of PSE
to provide adequate facilities, personnel and support
for options trading. * * * The way order-routing
decisions are made by a large number of securities
firms, however, insures that the bulk of business
will be done at the CBOE or Amex, even though PSE
might provide a better market, either generally or
frequently.

This process is illustrated well by a study PSE
conducted of trading in Houston Oil and Minerals
options, a class of options which PSE began trading
simultaneously with CBOE. 138/ Officials recorded PSE's
quotes and CBOE's quotes periodically during the day for
10 trading days in December [1976] . This study * * *
showed the markets being quoted by PSE market makers
generally to be somewhat superior to the market quoted
on the CBOE. Despite the quality of the markets made
by PSE market makers, and despite lower execution costs
resulting from PSE's practice of having exchange

137/ Id.

138/ The PSE study comparing PSE and CBOE markets during December, 1976
is contained as Appendix Exhibit 8. It should, of course, be noted
that option quotations were not firm and did not contain size
at the time of the PSE study. See n.176 and discussion at 258-266,
infra.

836

employees operate the order book, the "market" in
Houston Oil and Minerals options moved slowly and
inexorably to the CBOE. 139/

The effect that a major retail firm's designation of a market center

as primary and subsequent routing of retail orders to that market center

139/ Statanent of the Pacific Stock Exchange, supra , n.136, at 1-2.
The AMEX stated that its experience with stocks and the primary
market designation is essentially the same as that of the options
exchanges. As AMEX has observed:

The experience of the Amex over the past couple of
years in attempting to maintain competing markets in
stocks of companies transferring their listing to the
NYSE provides some interesting comparisons. There have
been approximately ten such companies which at the time
of listing on the NYSE elected to also retain their Amex
listing. At the time of such transfer, the Amex was
receiving practically all of the order flow in each security.
Almost immediately after the transfer the NYSE was desig-
nated as the primary market for the security by a sizable
number of firms and they redirected substantially all of
their order flow to that exchange. Despite extensive
efforts by the Amex specialists involved to make fair,
orderly and competitive markets in such securities they
were unable to stem the redirection of the order flow
to the NYSE market.

Experience shows that during the first few weeks
following each transfer, order flow was split between
the two exchanges. But within a matter of several weeks,
or a few months at most, the image of the NYSE as the
primary market for these stocks spread to practically all
member firms and order flow to the Amex dwindled to a mere
trickle — despite the highly competitive markets being made
by Amex specialists, the reduced floor commissions that
were sometimes offered and the special attention given to
the furnishing of prompt service. At present, only three
of such companies are actively traded on both NYSE and Amex,
and for the first seven months of 1978 the Amex share of
the total volume in these issues was a miniscule seven-tenths
of one percent.

AMEX Letter, supra, n.90, at 16-17.

837

may have on the competitive balance between exchanges and marketmakers
is most vividly shown by a recent situation involving CBOE, AMEX and
Merrill Lynch. On May 19, 1978, Merrill Lynch changed its primary
market designation for American Express, Bally Manufacturing Corporation
("Bally"), Digital, and National Semiconductor Corporation ("National
Semiconductor") option classes from CBOE to AMEX. The decision was
made as a result of "operational difficulties" that Merrill Lynch
had encountered on CBOE and did not involve a "judgment concerning
the quality of the markets on either exchange * * * ." 140/ Table
16 summarizes CBOE total and public customer monthly contract volume
and market share for the four classes involved in the change of
designation from January, 1978 through October, 1978. The table shows
that CBOE's contract volume and market share declined significantly
after the Merrill Lynch change. In American Express, for example, CBOE
averaged 53 per cent of the total volume from January through April,
1978, but averaged only 41.20 per cent of this volume from June through
October. More dramatically, CBOE averaged 65 per cent of the total
public volume between January and April, but averaged only 42.40 per
cent of this volume during the June through October period. Similarly,
CBOE total market share averaged 57.50 per cent, 63.50 per cent, and
83.25 per cent in Bally, Digital, and National Semiconductor, respectively,

140/ Letter to Roberta S. Karmel from Wallace 0. Sellers, supra, n.122,
at 1.

838

from January through April but these average market shares fell to 37.60

per cent, 36.00 per cent, and 64.80 per cent from June through October.

Varying by like amounts, CBOE average percentage of total customer volume

declined from 63.25 per cent for Bally, 63.50 per cent for Digital, and

92.00 per cent for National Semiconductor in the January to April period

to 31.40 per cent, 32.20 per cent, and 65.60 per cent respectively during

the June to October period. Tables 17 A - D demonstrate these declines

graphically.

This experience indicates that primary market designations may become

self-fulfilling prophecies. More specifically, Merrill Lynch1 s decision to

route automatically its customer orders to AMEX made AMEX the primary market

for American Express, Bally, and Digital options even though the quality of

CBOE's market had in no way changed. In other words, the switching of

Merrill Lynch customer orders in these three classes gave AMEX sufficient

volume to become the "primary" market and thus to justify the automatic

routing of customer orders to that exchange. As CBOE has stated:

[I]t is clear that a great many firms follow the
practice of designating as the "primary market"
for a given class of options the exchange having
the largest public order flow in that class. Con-
sequently, the decisions of a relatively few
firms commanding large order flows tend to be
determinative of the designations of all others,
thus entrenching the position of the designated
exchange and making it more difficult for other
exchanges to compete on the basis of intrinsic
merit. 141/

141/ CBOE Letter, supra, n.87, at 12-13 (footnotes omitted).

839

It must also be recognized that a broker's obligation to obtain the
best price for his customer under the circumstances may not be completely
discharged at the time that an order is sent to a market center. If, for
example, significant pricing disparities exist between markets, it may
be necessary to check the markets at other market centers before executing
a customer's order to assure that a better price is not available elsewhere.
The markets at other market centers may be checked by observing the quotations
that the other market centers disseminate 142/ or by calling the upstairs
trading desk using the firm's direct line telephones on the trading floor.
Currently, however, there is no mechanism for routing orders in multiply
traded option classes from one option exchange floor to another. Without
such a market linkage system, option orders for multiply traded classes
can not be sent directly from one exchange to another promptly and efficiently
even if quotation or other quality of market information suggests that a
better price may be obtainable on an exchange other than the one to which
it was originally sent.

3. Market Fragmentation, Option Pricing, and
Order Interaction

It has been argued that security prices in a fragmented market "will

be less likely to reflect a prompt and complete assessment of current

value by all buying and selling interest" than if all orders for the

142/ Option quotation information from all exchanges trading a particular
class is generally available on cathode ray tubes on the options
exchange trading floors.

840

security are brought together and permitted to interact. 143/ Further,
concern has been expressed that the "mix of buy and sell orders in a
particular market may differ significantly from the mix in another market,
and, thus, lead to disparate pricing decisions in the two markets." 144/

The pricing of Bally options at the opening on September 1,
1978 illustrates these problems. Table 18 compares the opening prices
for Bally calls on AMEX and CBOE on September 1, 1978 in the
November, February, and May 60 and 70 series. This table indicates
that the opening prices on the two exchanges varied significantly for
each series. The November 70 series, for example, opened at $10 on
AMEX and $5 on CBOE and the February 70 series opened at $13 on AMEX
and $9 on CBOE. The table also shows that these differences in opening
prices can not be wholly, or even largely, attributed to changes in
the price of the underlying stock. The November 70 series, for instance,
opened at $5 at 10:44 E.S.T. with the stock at $62 1/4 while AMEX
opened at $10 twenty minutes later with the stock at $61 7/8. Similarly,
the February 70s opened at 11:01 E.S.T. on CBOE at $9 with the stock
at $62 3/4 but opened at $13 on AMEX ten minutes later with the stock
down to $60 3/4.

These pricing disparities appear to be primarily attributable
to imbalances of supply and demand on AMEX. In the November 70 series,

143/ Securities Exchange Act Release No. 13662, supra, n.124, at 959.
144/ CBOE Letter, supra, n.87, at 11.

841

for example, the AMEX specialist sold 675 contracts and AMEX ROTs sold
95 contracts at the opening. Total opening volume, however, was 1481
contracts. Thus, public demand exceeded public supply by approximately
100 per cent for that series, and it appears that the opening price reflected
this imbalance as well as the risk that the specialist assumed to fill
the public demand. In the February 70 series, the situation was much
the same. The specialist sold 280 contracts and ROTs sold 320 contracts
at the opening on volume of 630 contracts, public demand exceeding public
supply by 2000 per cent. 145/ On CBOE, on the other hand, total opening
volume in the November 70 series was 196 contracts with members of the
public buying 126 contracts and selling 135 contracts and CBOE marketmakers
purchasing only 9 contracts. In the February 70 series, CBOE opening
volume was 150 contracts. The public demanded 120 contracts and supplied
18 contracts, and CBOE marketmakers filled the remaining demand. 146/
This example illustrates that market fragmentation may adversely
affect the pricing of multiply traded options. It also demonstrates that
dispersion of public orders among market centers under existing circumstances
may preclude a portion of those orders from interacting and obtaining
an execution at the best price available. Public buyers of the Bally
November and February 70s whose orders were executed on AMEX at AMEX

145/ See Table 14.
146/ Id.

842

opening prices, for example, may have been able to purchase the same
options on CBOE at the same time for substantially less. These orders,
however, did not have an opportunity to interact with public orders
that had been sent to CBOE and were not exposed to CBOE marketmakers.
Thus, CBOE public orders and excess marketmaking capacity were not
used to minimize the effects of the imbalance of public orders on AMEX
and to distribute the risk associated with such a severe imbalance among
market participants who may have been willing to assume such risk. 147/

In sum, neither AMEX nor CBOE opening prices reflected a complete
assessment of all the buying and selling interest in Bally options and,
as a consequence, neither marketplace was able to price these options
accurately. Moreover, public orders that had been sent to either exchange
may not have been executed at the most favorable prices available since
they were not exposed to the full interplay of supply and demand. This
example, however, is clearly the exception rather than the rule. Dispersion
of order flow among market centers need not result in pricing inefficiencies
since public dissemination of quotation and transaction information
may to a large extent assure that professional and nonprofessional
market participants "are apprised, on a current and continuous basis,

147/ The minimal involvement of CBOE marketmakers in the CBOE openings
and the fact that CBOE marketmakers participated in transactions
for 7,812 contracts of Bally options on September 1, 1978 (52.5 per
cent of total CBOE volume) suggest that CBOE had excess marketmaking
capacity at the time of the AMEX opening.

843

of those markets offering the most favorable execution opportunities (at
least for orders of modest size) so that they have the opportunity to
direct * * * orders appropriately * * * ." 148/ In addition, competition
among marketmakers' on the floors of exchanges multiply trading an option
class and, in many circumstances, the trading activities of professional
traders and arbitrageurs may discipline option pricing among market
centers to a substantial degree. 149/

C. Conclusions

1. The Multiple Trading of Standardized Options
and the Exchange Act

The 1975 Amendments direct the Commission "to facilitate the

establishment of a national market system for securities." 150/ A

national market system is intended to encompass "all segments of the

corporate securities markets including * * * options" 151/ and has

"as a fundamental goal the elimination of fragmented markets for

securities suitable for auction trading." 152/ Primary objectives of

a national market system are (i) "the centralization of all buying and

148/ Securities Exchange Act Release No. 13662, supra, n.124, at 961.

149/ The trading activities of professional traders and arbitrageurs
are described in Chapter III.

150/ Section llA(a)(2) of the Exchange Act [15 U.S.C. 78k-l(a) ( 2) ] .

151/ Senate Report, supra , n.17, at 7. See also Conference Report,
supra, n.18, at 92.

152/ Id., at 17. See also House Report, supra, n.21, at 50.

844

selling interest so that each investor will have the opportunity for

the best possible execution of his order," 153/ and (ii) "the linking of all

markets * * * through communication and data processing facilities

[to] foster efficiency, enhance competition, increase the information

available to brokers, dealers and investors, facilitate the off-setting

of investors' orders, and contribute to best execution of such orders." 154/

The Exchange Act "approaches the problem of encouraging the develop-
ment and implementation of a national market system from the point of
view of preserving the competing markets for securities that have
developed, breaking down all barriers to competition that do not serve
a valid regulatory purpose, and encouraging maximum reliance on communi-
cation and data processing equipment consistent with justifiable costs." 155/
The Exchange Act seeks to "enhance competition and to allow economic forces,
interacting within a fair regulatory field, to arrive at appropriate
variations in practices and services," 156/ and "open competition among
market makers" is to assure that investors "obtain the best execution
of their orders" and that "the total market for each security is as

153/ Id., at 7. See also House Report, supra, n.21, at 50-51.

154/ Section HA(a)(l) of the Exchange Act [15 U.S.C. 78k-l (a)(1)]

155/ Senate Report, supra , n.17, at 8. See also House Report,
supra, n.21, at 15.

156/ Id. .

845

liquid and orderly as the characteristics of that security warrant." 157/
Moreover, existing market centers are to "compete and evolve according
to their own natural genius." 158/

Multiple trading is at the heart of the national market system that
the Congress envisioned. Clearly, market centers can not compete for
orders if they do not permit the trading of the same securities, and
marketmakers can not "make simultaneous markets" 159/ or have an
opportunity to "active [ly] participat[e] in the flow of orders" 160/
if they are not trading the same securities. When adopting the 1975
Amendments, the Congress recognized this fact and concluded that multiple
trading was "appropriate to a national market system in which all market-
makers and brokers are permitted to deal freely with one another without
unnecessary regulatory constraints." 161/

Multiple trading, however, should occur "within a fair regulatory
field" 162/ to be consistent with the Exchange Act. 163/ Moreover, to

157/ Id., at 12.

158/ House Report, supra, n.21, at 51.

159/ Senate Report, supra, n.17, at 14.

160/ Id. See also House Report, supra, n.21, at 50.

161/ Senate Report, supra , n.17, at 20.

162/ Id., at 8; House Report, supra, n.21, at 51.

163/ Section llA(a)(l), for example, provides that competition among
brokers and dealers and among market centers must be "fair."

40-940 O - 79 - 56

846

the extent that multiDle trading (i) inhibits "economically efficient
execution of securities transactions," 164/ (ii) precludes "the
practicability of brokers executing investors' orders in the best
market," 165/ (iii) results in market fragmentation, 166/ or (iv) imposes
a burden on competition "not necessary or appropriate in furtherance
of the purposes of [the Exchange Act] ," 167/ it may be deemed inconsistent
with the Exchange Act.

2. The Multiple Trading Experience
The effects that multiple trading has had upon the markets for
multiply traded option classes are difficult to measure. Data that
the Options Study gathered, however, suggest that multiple trading may
improve the quality of the markets for multiply traded classes, at
least over the short term. Although movements in the prices of the
underlying stocks and changes in the mix of in- and out -of -the -money
series may influence the prices of multiply traded options, analysis
(i) of classes that did not experience such stock price movements or

164/ Section HA(a)(l) of the Exchange Act [15 U.S.C. 78k-l(a) (1)] .

165/ Id.

166/ See discussion at 49-65, supra and 71-75, infra.

167/ Sections 23(a)(2) [15 U.S.C. 78w(a)(2)]. See also Sections 6(b)(8),
15A(b)(9), 19(b)(2), and 19(c) [15 U.S.C. f(b)(8), o-3(b)(9), s(b)(2)
and ( c ) .

847

changes in series traded, and (ii) which took these factors into account
indicate that price continuity, liquidity, and depth for multiply traded
classes may improve after the initiation of multiple trading. 168/ In
fact, improvements within the first few weeks of multiple trading may
be quite dramatic. The Options Study, however, was not able to determine
the duration of such improvements due to the short period for which
it had requested data and the increasing influence that other market
factors exert on option prices as time passes.

Multiple trading has had other important effects on the markets for
multiply traded classes. For example, it has at least partially caused
competing exchanges and potential competitors to develop automated order
routing and processing systems and to improve their floor operations
in an effort to attract or keep orders for multiply traded options.
In addition, multiple trading has in some instances caused competing
brokers, similarly trying to attract or keep option orders, to reduce
the commissions for executing orders in multiply traded classes. Perhaps
most significantly, multiple exchange option trading has provided market

168/ More subjectively, professional options traders, on and off exchange
floors, with whom the Options Study spoke were almost unanimously
of the view that multiple trading had generally improved the quality
of the market for multiply traded classes.

848

participants with a choice of markets in which to execute their orders
and has increased the marketmaking capacity with which these orders
can interact.

It must be kept in mind, however, that experience with multiple
exchange option trading is still limited. For example, of the 218 option
classes that are presently traded on the options exchanges, only 15 are now
traded on more than one exchange. Moreover, these 15 are among the
most active and liquid of the listed classes. Whether improvements in
market quality, operational and other efficiencies, and enhanced competition
among exchanges and among brokers and dealers would result from the
multiple trading of less active and less liquid classes, and, if so, to
what extent, are questions that the Options Study has not addressed.
The Options Study believes that such questions are better answered by
data 169/ and experience than by theory. 170/

169/ See, e^. , Special Study, supra, n.63, at 942.

170/ In this regard, it should be noted that the least active class

traded on CBOE in 1977 had an average daily volume of 65 contracts,
that 4 classes listed on that exchange had average daily volume
of less than 100 contracts in that year, and that 16 classes had
average daily volume on less than 200 contracts during that time.
CBOE Market Statistics - 1978, at 5.

849

Multiple exchange option trading has also resulted in significant
fragmentation of the markets for classes traded on CBOE and AMEX.
PHLX, PSE, and MSE, on the other hand, have not been able to attract
sufficient orders in classes that CBOE or AMEX also trade to compete
effectively with these exchanges. In fact, the PHLX and PSE
have been compelled to delist most of the classes that they have
multiply traded with CBOE or AMEX, 171/ and significant fragmentation
of the markets for multiply traded classes exists only with respect
to classes that both CBOE and AMEX list.

3. Market Fragmentation and the Exchange Act
The fragmentation of the markets for multiply traded option classes
may be inconsistent with some purposes of the Exchange Act. At present,
buying and selling interests for multiply traded classes are not centra-
lized 172/ and "the linking of all markets * * * [to] facilitate the
off-setting of investors' orders, and contribute to best execution of
such orders" 173/ has not occurred. Although the Congress intended that

171/ See Table 1.

172/ See discussion at 5 -52, 61-65, supra.

173/ Section llA(a)(l) ^c the Exchange Act [15 U.S.C. 78k-l(a) (1)] .

850

market fragmentation would be eliminated in the securities markets by

creating a national market system which would electronically tie together

all market centers that trade the same security, this goal has not been

realized with respect to multiply traded options. As the Senate Securities

Industry Study stated:

The dangers of market fragmentation must be evaluated
in light of the objectives of the Exchange Act. There
appears to be general agreement that the success and
quality of an auction market depend on a concentration
of public buying and selling orders in the market.
In other words, if the maximum benefits of market
centralization are to be achieved, the full interplay
of supply and demand must be present in a single
market. Therefore, looked at solely from this point
of view, any "diversion" of orders * * * would be
inimical to the public interest. It does no£, however,
follow from this that all orders should be "brought
back" to [one market center] . What does follow is
that all steps possible should be taken to develop
promptly a national market system within which the
full interplay of supply and demand can properly be
reflected. * * * What is required is not the
encouragement of the concentration of order flow in
[one market center] , but the development and
implementation at the earliest possible time of a
strong communications systems linking all markets
and all market makers. 174/

To achieve the "maximum benefits of market centralization," the

Commission and the self-regulatory organizations would need to develop "a

174/ Senate Securities Industry Study, supra , n.60, at 44-45.

851

strong communications system linking all markets and market makers"
for multiply traded options. Such a system would be designei to
assure "economically efficient execution of * * * transactions,"
"the practicability of brokers executing investors' orders in the best
market," and, consistent with these factors, the opportunity "for
investors' orders to be executed without the participation of a
dealer." 175/ As first steps toward this end, the Commission and the
self-regulatory organizations should begin to develop market linkages
which would provide for (i) coordinated openings among all markets that
permit the trading of an option class, and (ii) a prompt and efficient
means of sending orders to purchase or sell multiply traded options
among all market centers that permit the trading of these options. When
evaluating plans to expand multiple exchange option trading, the Commission
may wish to evaluate specifically the steps that have been taken to
develop such market linkages. In addition, to the extent that quotation
information that is currently available must be improved to permit maximum
utilization of a market linkage system, the Commission and self-regulatory
organizations should begin to consider the improvements that need to

175/ Section llA(a)(l) of the Exchange Act [15 U.S.C. 78k-l(a) (1) ] .

852

be made in the quotation gathering and dissemination procedures of the
options exchanges and the best methods for implementing such improvements
"at the earliest possible time." 176/

176/ The effectiveness of an intermarket linkage system is to a large
extent dependent upon the quality and reliability of the market
information that the connected market centers disseminate. The
Intermarket Trading System ("ITS") for certain stocks, for example,
is an electronic intermarket order routing facility which permits
orders for the purchase and sale of multiply traded stocks to be
sent directly from one market center to another. See Securities
Exchange Act Release No. 14416 (January 26, 1978), 14 SEC Docket
31, (February 7, 1978) (the "January Release"), and Securities
Exchange Act Release No. 14661 (April 14, 1978), 14 SEC Docket
806 (May 2, 1978). The ITS system, however, is based upon the
availability of composite quotations for all stocks that are traded
through the ITS linkage.

Pursuant to Commission Rule llAcl-1, each self-regulatory organization
is obliged to collect and disseminate to vendors quotations and
quotation sizes for all stocks as to which last sale information
is publicly disseminated via the consolidated transaction reporting
system. 17 C.F.R. 240.11Acl-l. See Securities Exchange Act Release
No. 14415 (January 26, 1978) and January Release, supra, at 38-39.
These quotations must be firm at the prices and in the amounts
displayed, subject only to exceptions for revised quotations or
quotation sizes and for unusual market conditions precluding
dissemination of accurate quotation information. With respect to
the relationship between this composite quotation system and order
routing, the Commission has stated:

The Commission believes that the availability of
comprehensive quotation information, a fundamental
building block of the national market system, will
improve both brokers' and public investors'
knowledge of current prices at which reported
securities can be bought or sold throughout the
country. In turn, availability of this information
should (i) lead to increased efforts by brokers
to make informed order routing decisions from among
the various competing market centers (in order to
choose that particular market affording at a
particular point in time, the most favorable

(footnote continued on next page)

853

4. Primary Market Designations and Automated
Order Routing

The existence of alternative market centers with the marketmaking

and operational capacity to absorb a substantial volume of retail

orders requires firms to determine to which market centers their customer

orders should be sent. Many brokerage firms may have too many

customer orders in multiply traded option classes to permit, under

present conditions, an order-by-order evaluation of the quality

of competing markets. These firms use their order routing systems

to transmit automatically small customer orders for these classes

to the exchange that a firm designates as "primary." Since volume

is usually a principal factor considered in making a primary market

(footnote continued)

execution opportunities to their customers); (ii)
foster improvements in existing methods of routing
orders to all market centers; [and] (iii) enhance
fair competition among markets; * * * .

January Release, supra , at 38-39.

Rule HAcl-1, however, does not apply to options trading. See
Securities Exchange Act Release No. 14415, supra , at 24, n.49.
Quotation information in the markets for multiply traded options,
therefore, often is not firm and does not contain the number of
contracts for which a bid or offer is good. As a consequence, it
may be difficult under prevailing circumstances for brokers on
one options exchange floor to evaluate accurately whether a better
market may exist for a multiply traded class on another exchange
even if a system linking the options exchange floors were in effect.
But see discussion at 260-265, infra, with respect to the difficulties
associated with obtaining firm quotes with size in the options
markets.

854

designation, the designation can become a self-fulfilling prophecy.
In other words, the exchange with the most volume in a multiply
traded class will be designated as "primary" and thus will receive
all automatically routed customer orders and more volume. As a result,
exchanges other than the exchange designated as primary are effectively
precluded from competing for automatically routed customer orders.
Without exposure to customer orders, it may be unlikely that an
exchange will be able to improve the quality of its market and
thereby to attract more orders in the future. Such improvements may
be unlikely because marketmakers on the secondary exchanges will not
be able to assess accurately the supply of and demand for, or to adjust
their positions easily with respect to, multiply traded classes if
they do not have an opportunity to be exposed to, and trade with,
customer orders. 177/

These order routing techniques may be largely responsible for the
delisting of most multiply traded classes by the secondary exchanges.
Once the large retail firms designate CBOE or AMEX as the "primary"
market for a multiply traded class and begin to route customer

177/ The Directorate of Economic and Policy and Research suggests that
public customers, not including member firms trading for their
own account, are involved in a mean of approximately 58 per cent
of the transactions that occur on the options exchanges. See
Directorate of Economic and Policy Research Memorandum to the
Commission, dated June 5, 1978, at 22.

855

orders to one of these exchanges automatically, the secondary exchange
may be unable to maintain the quality of its market for that class and
ultimately may be unable to attract sufficient orders to maintain
any market at all; 178/ This' result has occurred even where °SE and p'ILX
have traded the same option class without CBOE or AMEX involve-
ment. 179/ In addition, experience has shown that major retail firm
decisions concerning where to transmit their customer orders can
effectively determine whether CBOE or AMEX will be the "primary"
market for a multiply traded class. 180/

Automated routing of customer orders for multiply traded options
on the basis of a primary market designation derived principally on
the basis of volume may have effects on competition which raise significant
issues under the Exchange Act. Furthermore, such order routing may
not fulfill the obligations of brokers to execute customer orders at
the best price available under the circumstances. More specifically,
the order routing techniques that many firms use may hinder "fair com-
petition among brokers and dealers [and] among exchange markets," 181/
and "the practicability of brokers executing investors' orders in the
best market." 182/

178/ See discussion at 45-46, 71, supra.

179/ See PHLX Letter, supra, n.88, at 6 and Appendix B.

180/ See discussion at 58-60, supra .

181/ Section llA(a)(l)(c) of the Exchange Act [15 U.S.C. 78k-l(a) (1) (c)] .

182/ Id.

856

On the other hand, "economically efficient" executions may be
obtained. 183/

Competition among options marketmakers and among the options
exchanges in multiply traded classes may not be fair because exchanges
that are not designated as "primary" and the marketmakers at those
exchanges do not have the opportunity to attract or interact with
orders that are automatically transmitted to the primary market.
This opportunity may be denied to these market centers and market
participants even if their market is of the same or better quality
at a particular point in time than that of the market designated
as "primary" and they have the marketmaking and operational capacity
to absorb customer orders that they might attract. Moreover, if
the quality of a market that is not designated as "primary" is better
than the "primary" market in a particular instance, automatic routing
of customer orders to the "primary" market will preclude the execution
of those orders "in the best market." Also, it may be difficult
for these market centers and marketmakers to improve the quality
of their markets and their competitive position if they do not have
the opportunity to interact with retail orders. 184/ As a result,

183/ Id.

184/ See n.177, supra.

857

automated order routing to a market designated as "primary" tends

to maintain the primacy of that market and to maintain the status

quo with regard to the volume and type of orders that other market

centers and their marketmakers can attract. This preservation of

the status quo may inhibit the development of strong, competing

market centers. 185/

The Congress recognized the problems associated with automated

routing of customer orders to a primary exchange. Section HA(c)(l)(E) 186/

of the Exchange Act was specifically added in 1975 to give the Commission

authority "to assure that any order transmission or switching system

utilized by a brokerage firm * * * operates in a manner consistent

with the development and operation of a national market system." 187/

As the Senate Report stated:

Large brokerage firms rely heavily on high speed
systems for the direction of orders to a designated
facility for execution. The Committee has been
informed that many of these systems are currently
geared to route orders for any particular security

185/ See, e.g. , n.174, supra , and accompanying text and January Release,
supra , n.176, at 45T"

186/ This section provides the Commission with rulemaking authority
to "assure that all exchange members, brokers, and dealers
transmit and direct orders for the purchase or sale of qualified
securities in a manner consistent with the establishment and
operation of a national market system." 15 U.S.C. 78k-l(c) (1) (E) .

187/ Senate Report, supra , n.17, at 104. See also House Report,
supra, n.21, at 41, 92.

858

to only one market center, e.g., the NYSE. The
functioning of such systems in this manner is
inconsistent with the development and operation
of a national market system. It may also be
inconsistent with a broker's obligation to
obtain "best execution" for his customers.
[Section HA(c)(l)(E)] would accordingly give
the SEC the responsibility to require brokers to
utilize order switching services which are "neutral"
as to market centers, giving preference to one
execution facility over another only to insure
best execution. 188/

More recently, the Commission has stated:

The Commission believes that all systems used
to route orders to and among qualified markets
should operate in a "neutral" fashion (i.e.,
they should permit brokers and dealers utilizing
those systems to route orders to and among all
such markets on a non-discriminatory basis).
Order routing systems which are not "neutral"
appear inconsistent with development of a
national market system since, among other things,
they may impede fair competition among aualified
markets and function in a manner incompatible
with broker adherence to principles of "best
execution." 189/

In accordance with this Congressional mandate and Commission policy,

it may be appropriate for the Commission, the self-regulatory organizations,

and the brokerage community to begin to develop more flexible methods that

brokerage firms can use to determine the exchange to which public orders

for multiply traded options should be sent. Although manual order -by-order

188/ Id., at 104-105.

109/ January Release, supra, n.176, at 39-40 (footnote omitted).
See also Securities Exchange Act Release No. 14885 (June 23,
1978), 15 SEC Docket 138 (July 12, 1978).

SoM

routing for multiply traded option classes may not be practicable due
to the time and cost involved for firms with substantial customer
volume, brokerage firms and the self-regulatory organizations should
consider the feasibility of designing automated order routing systems
that (i) consider the size of the public orders in relation to current
quotations in the markets that permit the trading of an option class
so that small orders can routinely be sent to the market offering
the best quotation, and (ii) permit the immediate rerouting of orders
from one market to another in the event that a market encounters
operational or other difficulties that may prevent the prompt and
efficient execution of public orders at the best available prices.
Of course, customers and registered representatives should also be
able to route orders when one market is clearly better than another.
As plans to expand multiple trading are presented, the Commission
may wish to consider the progress that has been made toward the
development of such order routing systems. Moreover, if the Commission
is not satisfied with the progress that is being made toward the
development of these systems, it may consider initiating rulemaking

860

proceedings to facilitate their establishment. 190/ Again, to the
extent that quotation information that the self-regulatory organizations
disseminate with respect to multiply traded classes needs to be improved
to provide an adequate basis for such modifications in the order routing
systems of the brokerage firms, the Commission, the self -regulatory
organizations, and the firms should work to establish a quotation
system that will meet the order routing needs of the industry. 191/

It should be noted that the Commission has solicited public
comments with respect to whether "the routing of [stock] orders, by
brokers, on an order-by-order basis, to the best market, in size,
as determined by quotations made available pursuant to Rule llAcl-1
under the Exchange Act, should be a characteristic of a national

190/ With respect to the development of neutral order routing facilities
for a national market system for certain stocks, for example, the
Commission stated:

Should development of comprehensive, "neutral" order
routing systems, linking all qualified markets and
permitting brokers and dealers to route orders to any
such market directly from their offices, not be under-
taken voluntarily by the self -regulatory organizations,
the Commision is prepared to initiate rulemaking to
consider appropriate means of ensuring that result.

January Release, supra , n.176, at 40.

191/ See discussion at 73-74, supra, and 258-268, infra.

861

market system." 192/ Commentators have strongly urged that

mandatory order-by-order routing to the highest bid or lowest offer

should not be an element of a national market system under existing

circumstances. The Securities Industry Association, for example,

stated :

We do not see how mandatory routing to the
highest bid or lowest offer will improve the
securities industry's ability to serve its
customers. In an environment of competing market
centers, the routing decision involves many
considerations, only some of which are subject
to mathematical quantification. Especially if
a customer's order is larger than one or two
round lots, the professional agent must evaluate
many factors such as available size, expected
depth of the market behind the quotation, 192a/

192/ Securities Exchange Act Release No. 14885, supra , n.189. Since
Rule llAcl-1 applies only to quotations for stocks included
in the consolidated transaction reporting system and standardized
options have not been included in recent national market system
initiatives, public views were not solicited concerning the
feasibility of order-by-order routing in the options markets.
See n.176, supra, and discussion at 258-265, and 266-268, infra.

192a/ The Securities Industry Association also noted "that while Rule
llAcl-1 under the Act requires responsible brokers and dealers
and third market makers to stand 'firm' behind so much size
as they have displayed in the composite quotation system, it
does not oblige such persons to display all the size in which

(footnote continued on next page)

40-940 O - 79 - 57

862

customer willingness to accept multiple tickets,
comparative execution costs, comparative clearance
and settlement costs, transfer tax consequences,
comparative floor Drokerage, market tone,
speed of execution, possibility of intraquote
execution, and so on. The agent must weigh
the possible advantages of routing to a
particular market against the risk of missing
the market posted in that — and possibly — other
market centers. * * * In the institutional
context, factors other than posted quotations
will heavily influence the agent's professional
judgment. Inasmuch as institutional interest
today accounts for more than two-thirds of the
composite transaction volume in listed securities,
mandatory routing to the highest bid or lowest
offer would be a uniquely inappropriate routing
technique. Competition for institutional customers
are especially intense, and institutional customers
are especially rigorous judges of the quality
of their executions. If persistent routing to
the highest quoted bid or lowest quoted offer
were an appropriate competitive strategy to
attract and retain such customers, the process
of competition already would have discovered
it.

(footnote continued)

they might conceivably be willing or able to trade. Notwithstanding
the composite quotation system, therefore, it will remain crucial
to effective customer service to evaluate professionally the
market behind any given quotation." Letter to George A. Fitzsimmons,
Secretary, Securities and Exchange Commission, from Robert H.
B. Baldwin, Chairman, Securities Industry Association, dated
August 4, 1978 at 12-15. (footnote omitted).

863

The implementation of the composite quotation
system makes it particularly urgent that the
upstairs community remain free to develop, through
the process of competitive evolution, routing
techniques which best fulfill their customers'
expectations. The Commission has often predicted
that the" composite quotation system will enable
brokers to make more informed routing decisions,
and foster improvements in existing methods of
routing. To the extent that the Commission's
forecast proves accurate, the upstairs community
will, under competitive pressure, adjust its
routing techniques and systems accordingly. It
would be counterproductive of the Commission's
expectation, and the interests of investors, to
deprive the upstairs community of the latitude
and the competitive impetus to make the most
efficient use of the newly available quotation
information. 192b/

These considerations may be equally applicable to order routing

decisions in the options markets. In addition, the derivative nature

of options pricing and the lack of firm options quotations with size

may make the development of automated order routing techniques for

standardized options even more difficult. 192c/ On the other hand,

192b/ Id. See also File No. S7-735.

192c/ See discussion at 73-74, supra, and 258-268, infra.

864

the competing marketmaker systems that the options exchanges use
may provide these exchanges with the capacity to absorb, at quoted
prices, any option orders of small size that may be received.

The Options Study is not aware of any studies that have been
conducted or data that have been gathered identifying (i) the
number of customer orders that are automatically routed to an
options exchange in multiply traded classes, (ii) the average number
of contracts involved with each order, and (iii) the frequency with
which these orders are transmitted. The Commission and the self-
regulatory organizations may wish to gather such data as a first
step toward the creation of order routing systems for multiply traded
options.

5. The Multiple Trading of Standardized Options and Recent

Initiatives Toward the Development of a National Market System

In January, 1978, the Commission announced the initiatives that it
considers "necessary to accelerate implementation of a national market

865

system. " 193/ These initiatives encompassed only stocks for which last
sale information is reported in the consolidated transaction reporting
system 194/ and included (i) improvements in the consolidated transaction
reporting system to refine "the way last sale information is distributed and
recalled for display," 195/ (ii) the establishment of a composite quotation
system to "improv[e] the quality of quotation information" with respect
to stocks included in the consolidated system, 196/ (iii) "the prompt
development of comprehensive market linkage and order routing systems to
permit efficient transmission of orders ( [a] ) among the various markets * * '
and ( [b] ) from brokers and dealers to all qualified markets," 197/ and (iv)
a central limit order file for public agency orders would assure that "all
agency orders in qualified securities, regardless of location, receive the
benefits of auction-type trading protections." 198/

Since January, certain steps have been taken to implement these
initiatives: Modifications have been made in the consolidated transaction

193/ January Release, supra, n.176, at 32.

194/ See 17 C.F.R. 240.17a-15. See also Securities Exchange Act Release
No. 12138 (February 25, 1976), 9 SEC Docket 8 (March 9, 1976).

195/ January Release, supra, n.176, at 42.

196/ Id., at 38.

197/ Id., at 39.

198/ Id., at 40.

866

reporting system; 199/ progress has been made toward the development

of a composite quotation system; 200/ market linkages have been established

between most of the market centers that multiply trade a stock included

in the consolidated transaction reporting system; 201/ and public discussion

has begun with regard to the appropriate method for achieving an

efficient order routing system from the offices of brokers and dealers

to all market centers 202/ and a central limit order file. 203/ When

evaluating plans to expand the multiple trading of standardized

options, the Commission should consider the effect that such expansion

may have upon the further implementation of these initiatives and

the overall development of a national market system. In this regard, it

should be kept in mind that Section llA(a)(2) of the Exchange Act directs

the Commission "to facilitate the establishment of a national market

system" 204/ and that Section 19(b)(2) of that Act requires that the

199/ See Securities Exchange Act Release No. 15250 (October 20, 1978),

14 SEC Docket 1355 (November 7, 1978).

200/ See Securities Exchange Act Release No. 14415, supra, n.176.

See also Securities Exchange Act Release No. 15009 (July 28, 1978),

15 SEC Docket 467 (August 15, 1978).

201/ See Securities Exchange Act Release No. 14661 (April 14, 1978), supra,
n.176.

202/ See File No. S7-735 and Securities Exchange Act Release No. 14885,
supra , n.189.

203/ See File No. S7-735.

204/ 15 U.S.C. 78k-l(a)(2).

867

Commission disapprove any proposed rule change of a self-regulatory organi-
zation if the Commission can not find that such a proposal "is consistent
with the requirements of [the Exchange Act]." 205/

Table 19 indicates the total amount of revenues that FHLX, PSE, and
MSE obtained from their options programs during 1976, 1977, and the first
three months of 1978. The table also indicates the percentage of total
exchange revenues that these options revenues represent. Data is presented
for these three exchanges because they are the only secondary stock market
centers that permit the trading of options and that are participating in
the implementation of the initiatives announced in the January Release. 206/
Table 20 shows the total income that these exchanges derived from their
options programs during the same time periods and the percentage of total
exchanges net income that options net income represents. Finally, Table
21 indicates the total amount of revenue that these secondary stock exchanges
obtained from transaction charges for options transactions on their floors
and the percentage of total options revenues that this amount represents.
Together these tables demonstrate the critical role that options revenues
play in the economy of these secondary stock exchanges. During 1977 and the

205/ 15 U.S.C. 78s-(b)(2).

206/ AMEX data is not presented because discrete options net income was
not available for this exchange. CBOE data is not presented
because CBOE derives all of its revenues from activities related
to options and, as an exchange that does not permit the trading
of stock, is not a participant in the recent initiatives to
develop a national market system.

868

first quarter of 1978, for example, options revenues made up more than
40% of the total revenues of PHLX and more than 30% of the total
revenues of PSE. More significantly, options net income accounted
for 186.7% of PHLX's net income in 1977 and 153% of PSE's net income
during the first quarter of 1978. Further, the $9716 of net income
that PHLX earned from its option program during the first quarter of
1978 was not sufficient to offset losses that the exchange sustained
from its other activities. MSE, by contrast, sustained losses throughout
the entire period including a $99,295 loss on its option program during
the first quarter of 1978.

This data suggest the profound effect that an expansion of multiple
trading of standardized options may have on the economies of these
secondary stock exchanges. If an expansion of multiple trading extends
to a significant number of the option classes that these exchanges
list and they lose even a small portion of their options orders, 207/ their
financial well-being, and thus their ability to participate as meaningful
competitors in the continuing development of a national market system,

207/ Table 20 illustrates the importance of options transaction charges
to the financial viability of PHLX, PSE, and MSE. On PHLX,
transaction charges presently account for more than 60 per cent
of total option revenues, and on PSE and MSE these charges amount
to more than 30 per cent of such revenues. Accordingly, a decline
in the number of options transactions executed on any of these exchanges
would directly and quickly impact the exchange's financial health.

869

may be jeopardized. As AMEX has stated with regard to expanded multiple

trading in the context of the NYSE Plan:

The Amex believes that the NYSE's entry into options
trading at this time poses a substantial risk that one
or more exchanges, faced with the loss of a significant
oart or all of their options business, may be unable
to withstand the resulting financial burdens and could
be forced to cease operations or seek to consolidate
with other market centers. This would not only have
repercussions in the options area but could also
seriously affect efforts to develop a national market
system for equity securities.

Other exchanges, operating with substantially
reduced order flow in options, will find that their
ability to compete is greatly impaired. As other
exchanges find it more difficult to compete, the
dominant position of the NYSE in both equities and
options will be further entrenched.

It is the Amex's view that if its options program
should falter, its equities market would also suffer
serious repercussions. Specialists and floor brokers
who currently depend on both securities to sustain
their operations would find that the reduced revenue
flow would be inadequate to enable them to maintain
an appropriate level of service. 208/

And as PSE has stated in the same context:

Dual trading of options by the New York Stock Exchange
is a question which cannot be addressed separately
from other national market system issues. At a time
when substantial progress is being made in the
development of a national market system composed of
competing equity market centers, it would be

208/ AMEX Letter, supra, n.90, at 60-61

870

particularly unfortunate to see this progress ended
by allowing dual trading of options by the New
York Stock Exchange. 209/

On the other hand, the Commission has twice stated that the "preser-
vation of any market's present share of national order flow" should not be
a determinative factor when weighing competitive consequences as a national
market system evolves. 210/ Indeed, the Exchange Act requires that the
Commission "balance the perceived anti-competitive effects of [a] regulatory
policy or decision at issue against the purposes of the Exchange Act that
would be advanced thereby and the costs of doing so" 211/ and does not
impose an obligation upon the Commission to justify its actions
as "the least anti-competitive manner of achieving a regulatory
objective." 212/

IV. THE INTEGRATION OF TRADING OF OPTIONS AND THEIR UNDERLYING SECURITIES

In 1935, the Commission requested that each national securities exchange
adopt rules prohibiting stock specialists and odd-lot dealers and their
firms and partners from acquiring options with respect to the stocks in

209/ PSE Letter, supra, n.89, at 7.

210/ See Securities Exchange Act Release No. 11942 (December 19, 1975),
8 SEC Docket 756 (January 5, 1976) and No. 13662, supra, n.124.

211/ Senate Report, supra , n.17, at 13-14. See also Conference Report,
supra, n.18, at 94.

212/ Id.

871

which such specialists or odd-lot dealers were registered. 213/ In addition,
the Commission requested that each exchange prohibit other members, while on
the exchange floor, from initiating the purchase or sale of stock for their
own account, or any account in which they or their partners had an interest,
if the member also had sold or purchased options on the same stock. 214/
The Commission suggested these rules because of abuses in the use of
options in the operations of manipulative "pools" during the late
1920' s and early 1930' s. 215/ It was the general view at the time of the
passage of the Exchange Act that options enabled "manipulators of every
sort" to "carry on large-scale operations with a minimum of financial
risk." 216/ Although such abuses were not limited to pool operations,

213/ See Letter to National Securities Exchange Presidents, from Joseph

Kennedy, Chairman, Securities and Exchange Commission, dated April 16,
1935.

214/ Id.

215/ H.R. Rep. No. 1383, 73d Cong. 2d Sess. 10-11 (1934). See also
S. Rep. No. 792, 73d Cong., 2d Sess. 9 (1934); Stock Exchange
Practices, Report of Comm. on Banking & Currency, S. Rep. No.
1455, 73d Cong., 2d Sess. 47 (1934). Manipulative pools were
typically composed of individuals who, after gaining access to a
substantial block of a particular security, engaged in a number
of activities, including the dissemination of false information
regarding the security and creating misleading indications of
activity and price movements designed to attract sufficient
public customers for the stock to allow the pool to dispose of
its stock position at artificially high prices. Cptions were
often used as a method of gaining access to the stock.

216/ Stock Exchange Practices, Report of Comm. on Banking & Currency,
S. Rep. No. 1455, 73d Cong., 2d Sess. 45 (1934).

872

the granting of an option to pools or confederates was found to be involved
with most manipulative schemes, and the services of a specialist
were considered invaluable to pool managers. 217/

Trie stock exchanges ultimately adopted rules similar to those that
the Commission had suggested. 218/ Professional securities traders and
marketmakers not on exchange floors, on the other hand, were not, and
have never been, subjected to comparable options trading restrictions.
Moreover, the ability of options marketmakers to trade underlying stocks
has never been limited.

Scon after the initiation of standardized options trading, the
Commission requested public comments on the question of "whether
specialists, marketmakers, floor traders and block positioners should be
permitted to trade or otherwise have an interest in options (puts and
calls) in any securities in which they are registered, make a market,
or trade for their own accounts on exchanges, either from on or off
the floor or in the over-the-counter market." 219/ Subsequently, the
Commission determined to permit specialists and odd- lot dealers on

217/ Id., at 47.

218/ See, e^. , NYSE Rules 96 and 105 and AMEX Rules 103 and 175.

219/ Securities Exchange Act Release No. 10312 (August 1, 1973),
2 SEC Docket 223, 224 (August 14, 1973).

873

the floors of the secondary stock exchanges to trade listed options

on their specialty stocks and to allow floor traders on those exchanges

to trade listed options with respect to underlying securities in which

such floor traders held a position. 220/ At that time, the Commission was

of the view that the potential for manipulative activity that might result

from such "concurrent trading" was "relatively insignificant" on the secondary

stock exchanges due to the small percentage of stock order flow directed to

them. 221/ The Commission, however, has not yet permitted specialists

on the primary stock exchanges to trade listed options with respect

to the stocks for which such specialists are registered and has

not allowed registered stock marketmakers on these exchanges to

trade options on the stocks in which such marketmakers hold positions.

Nor has the Commission permitted the trading of standardized options

and their underlying stocks at the same physical location on an exchange

floor. In 1975, when approving the PHLX proposal to allow standardized

options trading on the PHLX floor, for example, the Commission stated:

[PHLX] is the first exchange to propose trading of an
option on the same exchange as the underlying security
is traded. In its plan, [PHLX] has undertaken to take

220/ See, e^g. , Securities Exchange Act Release No. 13269 (February 16,

1977), 11 SEC Docket 1741 (March 1, 1977); No. 13270 (February 16,

1977), 11 SEC Docket 1742 (March 1, 1977), No. 13271 (February 16,

1977), 11 SEC Docket 1743 (March 1, 1977); and No. 13272 (February
16, 1977), 11 SEC Docket 1744 (March 1, 1977).

221/ Id.

874

action * * * to lessen potential regulatory
problems associated with such trading; [Among other
things,] the Exchange will physically separate the
option trading floor from its regular floor for trading
stocks and other securities to prevent visual and
direct auditory communication between the two trading
areas. This action is designed primarily to bar the
misuse in its options market of information obtained
by floor members relating to activity in an underlying
security where the information has not yet received
public dissemination * * * . 222/

Similarly, when approving the MSE plan to permit standardized options trading

on that exchange in December, 1976, the Commission specifically noted that

MSE had "constructed a separate floor for trading options." 223/

Many proposals have been made to integrate further the markets for

options and their underlying securities. This tendency toward integration

appears to result because (i) option prices are to a large extent

dependent upon, and derivative from, the prices of their underlying

securities, and (ii) integrating the trading of options and their

underlying stocks may enhance the liquidity of both stock and options

markets. NYSE, for example, has proposed to permit its stock specialists

to trade options on their specialty stocks and to allow registered

NYSE stock marketmakers to trade options for their own accounts. 224/

222/ Securities Exchange Act Release No. 11423, supra, n.74f at 896.
See also Securities Exchange Act Release No. 12283 (March 30,
1976), 9 SEC Docket 317 (April 13, 1976), and No. 13045 (December 8,
1976), 11 SEC Docket 1120 (December 21, 1976).

223/ Securities Exchange Act Release No. 13045, supra, n.222, at 1120.

224/ SR-NYSE-76-54 . See also Securities Exchange Release No. 12924
(October 27, 1976), 10 SEC Docket 786 (November 9, 1976), and
NYSE Letter, supra, n.85, at 9-10.

875

In addition, PSE and PHLX, as secondary exchanges for stocks on
which standardized options are traded, have oroposed the elimination
of the physical barriers that separate the stock and options trading
floors at those exchanges. 225/ Further, MSE and PSE have proposed 226/
that their members be permitted to hold simultaneous appointments
as options marketmakers and registered stock marketmakers, in the
case of MSE, or alternate stock specialists, in the case of PSE. 227/
Moreover , CBOE 228/ and NASD 229/ have proposed to permit the trading of

225/ SR-PSE-77-13; SR-PHLX-77-6. See n.8, supra .

226/ SR-MSE-77-28; SP-PSE-77-17. See n.9, supra.

227/ None of the secondary stock exchange proposals, however, would
remove existing restrictions prohibiting stock specialists
on these exchanges from holding option marketmaker appointments.
SR-MSE-77-28, SR-PSE-77-17. See n.9, supra.

228/ CBOE Plan, n.6, supra. CBOE submitted a proposal that would
permit the trading on its floor of stocks and other securities
exchangeable or convertible into those stocks. Currently, only
standardized options are traded on the CBOE floor. The CBOE
Plan proposed to utilize a competing marketmaker system for
the trading of stock and other non-option securities. This
system, like the CBOE options market, would depend upon multiple
marketmakers, with marketmaking obligations identical to those
currently imposed upon registered CBOE option marketmakers,
to perform the marketmaking function. CBOE Plan, Proposed Rule
8.7. Also like the CBOE options market, limit orders would be
handled and executed by independent Board Brokers who would perform
no marketmaking function and would not be permitted to trade for
their own account.

229/ NASD Plan, n.4, supra. This Plan is described in Section V of
this chapter.

876

options and their underlying securities at the same physical
location 230/ and by the same individuals and firms. 231/

This section will discuss various factors that the Commission
should consider when evaluating proposals to permit the further
integration of trading in options and their underlying securities
on an exchange floor. It will also make some general observations
concerning, among other things, the integration proposals that have
been made. The NASD proposal to permit dual marketmaking in the
over-the-counter markets will be considered in the next section.

A. The General Considerations

To evaluate particular proposals to integrate the trading of options
and their underlying securities, the Commission should weigh and
balance various competing considerations. Improvements in the quality
of the markets for stocks and their related options that may result
from integration, for instance, must be balanced against (i) competitive
and market information advantages that may accrue to certain market

230/ Trading derivative and underlying securities at the same physical

location will be referred to in this chapter as "side-by-side

trading." This practice has also been referred to as "contiguous
trading."

231/ Simultaneous marketmaking in an option and its underlying security
by the same person or firm will be referred to as "dual marketmaking'
in this chapter.

877

participants, (ii) opportunities to engage in manipulative and other
improper trading practices that may be created, (iii) possible conflicts
between stock and options marketmaking obligations that may arise,
and (iv) increased difficulties in conducting adequate market surveillance
that may accompany integration. Moreover, when attenuating to quantify
improvements in market quality and the severity of the regulatory
concerns that may result from a particular integration proposal, the
extent of integration proposed and the characteristics of the market center
making the proposal should also .be taken into account.

1. The Quality of Markets

The primary purpose of most proposals to integrate the trading of

options and their underlying securities is to improve the liquidity

and depth of the markets for both securities. NYSE stated this rationale

in connection with its concurrent trading proposal:

If concurrent trading were permitted, specialists
— who are also odd-lot dealers — and other market-
makers would be able to use options to hedge stock
positions acquired in fulfilling their obligations
to the marketplace in the underlying stock. Clearly,
this would reduce market-making risks, facilitating
specialists' ability to buy or sell blocks of stock
when there is an absence of orders. Similarly,
specialists would be better able to maintain fair
and orderly markets when there is a disparity between
supply and demand. Allowing specialists to use op-
tions to hedge stock positions would increase their
ability and willingness to commit capital to market-
making in the underlying stocks. Thus, the end
result would be to improve specialist performance

40-940 O - 79 - 58

878

and enhance the depth and liquidity of NYSE markets
in listed securities. Similar market benefits could
be expected to accrue from the ability of competitive
traders and registered competitive market-makers to
engage in options trading. 232/

Integration may also result in pricing efficiencies in the markets

for options and their underlying securities. Option pricing efficiencies

may be obtained if integration provides option marketmakers with more

quotation, transaction, and order information with respect to trading in

underlying securities more quickly than is currently the case. Similarly,

integration may improve stock pricing efficiency if stock marketmakers

are able to obtain more rapidly quotation, transaction, and order information

concerning option trading that may be indicative of changes in the supply

of or demand for a stock. Such information may permit stock and options

marketmakers to adjust their quotations and positions to reflect more

rapidly and more accurately changes in supply and demand for their

securities. 233/

232/ NYSE Letter, supra, n.85, at 10.

233/ Ultimately, increasing the pricing efficiency in the markets
for options and for their underlying securities may improve
the liquidity of the markets for both securities. This result
may obtain because stock and option marketmakers may be able
to reduce the risks that their marketmaking activities entail.
These risks may be reduced because marketmakers may be more
certain that their transactions and quotations reflect more
recent and complete order, transaction and quotation information
concerning both the stock and its related options. With reduced

(footnote continued on next page)

879

Operational efficiencies may also result from integrating the
trading of options and their underlying securities. Options marketmaker:
for example, may be able to execute orders in underlying securities
more quickly and more economically if they are present on a floor
where underlying securities are traded. 234/ Less costly and less
time-consuming executions for combined stock-option orders may also
be obtained. 235/ Further, brokerage firms may be able to utilize
floor personnel more efficiently, to transfer more discretion for
combined stock-option orders to their on-floor brokers, and to reflect
such efficiencies in lower commission charges. Exchange order routing
and orocessing facilities might also be adapted to an integrated
trading environment to obtain routing and execution efficiencies for
retail and other member firms. 236/

(footnote continued)

risks, stock and options marketmakers may be able to narrow the
spreads in their quotations, and, by bidding and offering in
greater size, to accumulate larger positions. This, in turn,
may facilitate deeper and more liquid markets for both securities.
Moreover, such increased depth and liquidity in the option
markets may further contribute to the liquidity of the markets
for underlying securities by improving the ability of market
participants to shift risks associated with positions in underlying
securities to the options markets.

234/ See, e.g. , discussion at 102-105, 224-227, infra.

235/ See, e^g., discussion at 218-219, 232, infra.

236/ See, e.g. , discussion at 232-233, infra.

880

2. The Regulatory Concerns

a. Market Information and Competitive Advantage
Market information is "information about events or circumstances which
affect the market for a company's securities but which do not affect the
company's assets or earning power." 237/ Market professionals on the floors
of the national securities exchanges, by virtue of their presence on the
exchange floors, have access to certain market information that is not
available to other market participants. These professionals, for example,
may observe orders, transactions, and patterns of trading and quotations
before such information is publicly disseminated. Indeed, significant
pieces of market information that may be observable on a trading floor
and suggestive of the supply of and demand for a security may never be
publicly disseminated. Market participants who are not on an exchange
floor, for instance, may never become aware of information concerning
unexecuted orders, indications of buying and selling interest in
a trading crowd, and the trading styles of particular market participants
because no mechanism exists for publicly disseminating such valuable
market information. In addition, stock and options specialists
with essentially exclusive access to the limit order book for their

237/ Fleischer, Mundheim, and Murphy, "An Initial Inquiry Into the
Responsibility to Disclose Market Information," 121 U. Pa. L.
Rev. 798 (1973).

881

securities possess information concerning the supply of and demand
for those securities that other market participants do not have
because information regarding the contents of a specialist's limit
order book need not be made publicly available. 238/

Access to these types of market information provides market pro-
fessionals on exchange floors with competitive advantages over other
market participants. Specifically, exchange members trading on exchange
floors may use the market information that they possess as a basis for
their trading activities. Further, the presence of these professionals
on an exchange floor frequently permits them to react virtually
instantaneously to the market information that they obtain and to enter,
and perhaps execute, their orders before others can receive and
act upon information that may be publicly disseminated. In addition,
floor members do not pay brokerage commissions when executing their

238/ It should be noted, however, that the Commission has recently stated
its belief that "one of the basic principles upon which a national
market system must be based is the assurance that all agency orders
in qualified securities, regardless of location, receive the benefits
of auction-type trading protection." January Release, supra, n.176,
at 40. Accordingly, the Commission encouraged the several self-regulatory
organizations to "take joint action promptly to develop and implement
a central limit order file (the 'Central File') for public agency
orders to buy and sell qualified securities in specified amounts
at specified prices ('public limit orders')." Id. In addition,
the Commission stated that it was not "aware of any compelling
reason why information as to all public limit orders in the Central
File should not be made publicly available on a current and continuous
basis, at least in summarized form." Id., at 41.

882

own orders and receive more favorable margin treatment for their
positions than other market participants. 239/ Traditionally,
market professionals on exchange floors have been permitted to
enjoy these market information and competitive advantages because
they have obligations to the markets for the securities that they
trade and have made significant contributions to the continuity,
liquidity, and depth of the markets for those securities. 240/

At present, options and their underlying securities are traded on
different exchange floors. As a consequence, stock specialists and
registered stock marketmakers are generally unable to observe option
trading and options marketmakers cannot regularly observe stock trading.
Market information and competitive advantages that these floor members
enjoy extend primarily to the markets for the securities for
which these marketmakers have explicit obligations. Integrating
further the markets for options and their underlying securities
may provide these marketmakers with market information and competitive
advantages that exceed those that they now possess and which extend

239/ See Chapter VII.

240/ See, e.g., Special Study, supra, n.63, at 76-83, 90, 127-128, 135,
and 203-242. See discussion at 114-115, infra, for a more detailed
description of the obligations that marketmakers on exchange floors
have assumed. Floor brokers, of course, have no such obligations
because they act only as agents and do not engage in marketmaking.

883

into markets in which they have no responsibilities. Options market-
makers, for example, may be able to observe, or otherwise obtain
information concerning, unexecuted stock orders, indications of
buying and selling interest for a stock, orders that are left with
a stock specialist, patterns in stock trading crowds, and stock
quotation and transaction information that these marketmakers cannot
now observe or easily obtain because of the physical separation
of stock and options trading floors. Similarly, integration may
permit stock specialists and registered stock marketmakers to observe,
or obtain information concerning, large option orders, indications
of buying and selling interest for particular option classes, and
patterns of option trading that may indicate imminent changes in
the supply of or demand for a stock. Integration may also allow
these market professionals to trade for their own account on the
basis of this information before it is publicly disseminated and
even if it is never publicly disseminated.

In light of the traditional balancing of the benefits derived
from the market information and competitive advantages that have
been granted to certain market professionals on exchange floors against
the contributions that these market participants have made to the
quality of the markets in which these advantages are enjoyed, it
may be contrary to much of the regulatory philosophy that has evolved
to permit professionals who have market information and competitive

884

advantages in one marketplace to use those advantages to achieve
personal gain in a related marketplace to which they have no responsi-
bility.

When a market professional uses market information and competitive
advantages to trade in a market to which he has some obligations, any
unfairness that may exist by virtue of his trading on such information
may be justified on the theory that the market as a whole and the
public are benefited by the professional's fulfillment of his obligations
to that marketplace. This justification may not apply if a professional
on an exchange floor derives market information with respect to the
market for one security and uses that information to profit by trading
in a market for another security.

In addition, when evaluating proposals to integrate the trading of
options and their underlying securities on an exchange floor, the Commission
should consider the extent of additional market information and competitive
advantages that would accrue to stock and options marketmakers on the
exchange that has proposed the integration and determine whether these
additional advantages are consistent with the statutory mandate that the
securities markets be "fair." 241/ In other words, integration proposals
should be designed to assure that there will be no "undue advantage

241/ See discussion at 19-21, supra.

885

or preference among participants in the marketplace" and that "differences
in opportunity and treatment" among market Darticipants making different
uses of, contributions to, and demands upon the market will be "held to
the absolute minimum consistent with the recognized differences." 242/

b. Manipulation and Other Improper Trading Practices
The integration of trading in options and their underlying securities
on an exchange floor may create opportunities to engage in manipulative
and other improper trading activities that do not presently exist. The
fact that substantial profits may be earned from options Dositions as a
result of small movements in the price of an underlying security may also
provide an incentive to engage in such conduct. Since it may be relatively
simple to move the price of an underlying security a small amount and
relatively difficult to detect improprieties associated with such small
movements, the opportunities to profit from improper trading conduct
may be substantial while accompanying risks may be minimal.

AMEX has provided two examples involving trading on nonpublic market
information by market professionals on an exchange floor that might
occur in an integrated environment and that may be considered improper.
In this regard, AMEX stated:

242/ Special Study, supra , n.63, at 14

886

First there is what might be described as "quote
racing". Assume the underlying stock is quoted in the
primary market at 59 to 3/8 (500 x 500), last sale
200 at 59. A broker enters the crowd with a limit order
to buy 5,000 shares at 59-1/4 and leaves the order with
the equity specialist. An options marketmaker (or his
partner or colleague, if the underlying stock is traded
some distance away from the option) observes the order
being given to the specialist and immediately asks for
the quote and size. The specialist advises him that the
new quotation is 59-1/4 - 3/8 (5,000 x 500), and then
sends the new quote for processing and dissemination
over the quote network. The options market maker can
react instantaneously to the significant increase in
size on the bid side of the market and, in anticipation
that this will cause the stock to trade up, take the
offer in one or more series of the related option
class, particularly a series the price of which,
because of the relationship of its strike price to
the current price of the underlying security, is
likely to move in direct relationship.

One may, of course, ask what is wrong with that
result? The investor who was offering options obtained
the price he was asking, didn't he? Yes, of course, the
investor obtained his asking price. But the floor
professional got a jump on every other potential purchaser
of those options based on his access to reliable market
information projecting increased demand for the underlying
stock and thus probable higher prices for the option.
Moreover, there is a possibility (perhaps not very
probable, but at least a possibility) that the investor
whose offer was taken by the floor professional, would
have withdrawn that offer and made an offer at a higher
price when the information showing strength in the
underlying stock became publicly available.

887

[Second] , "Tape racing" offers floor professionals
perhaps even greater opportunities to gain trading
advantages over off -floor market participants because
there is even less "guess-work" involved. Being
aware that a trade has actually taken place in the
underlying stock amounting to a significant price
movement, the floor professional can quite confidently
hit bids or pick off offers in the related option ,
secure in the knowledge that once the stock trade is
printed there is very likely to be a similar movement
in the price of the option.

The price movement in the underlying stock need
not be dramatic in order to offer the floor professional
an attractive trading opportunity. For example, assume
the market in the underlying stock is 99 to 1/4. An
order is entered to buy 2,000 shares at the market.
This order is executed— 200 shares at 99-1/4, 500 at
99-3/8, 300 at 99-1/2 and one thousand at 99-5/8.
This upward pressure will clearly be reflected in a
strengthening of the buying interest in the related
options, particularly those series that have a strike
price close to the current market price of the stock
or are "in the money". Therefore, the floor professional,
observing this activity in the underlying stock (or
being informed thereof by his partner or trading
colleague), buys options at the offer before the
stock trades appear on the tape. Once information
concerning this trading activity in the underlying
stock reaches the public and is displayed at the
options post, it is very likely that the price of
the various series of the related class of options
will react in a corresponding fashion, and the floor
professional will be able to liquidate his position
at a profit.

These examples demonstrate how rather routine trading
situations * * * can provide significant opportunities
for floor professionals to gain trading advantages. All
that is needed is a few seconds for the floor professional
to react while the market information is being processed
and disseminated. Moreover, a great deal of market
information, although very valuable to the floor professional
in predicting immediate price trends in a security, may
never be disseminated publicly. The fact that a particular
broker who has previously evidenced interest in a security

888

has become active in the trading crowd; knowledge that a
large order is being "worked" by a broker; the amount of
activity building up in a trading crowd; these and other
"tell-tale" indications are easily perceived by the
knowledgeable floor professional and, if acted on
promptly, can be turned into a trading advantage in
the options market. 243/

In addition, opportunities for stock and options marketmakers to

trade stock or options while in possession of nonpublic information

concerning block transactions may be enhanced in an environment in which

stock and options trading is integrated. Permitting a stock specialist

to trade options with respect to his specialty stocks or a registered

stock marketmaker to trade options for his own account, for instance,

may give these market professionals opportunities that they do not now

possess to trade options on the basis of block information concerning

underlying stocks that may be derived, in large part, as a result

of their stock marketmaking functions. An example may help to illustrate

this point: Assume that XYZ stock and related options are traded at the

same physical location on the floor of an exchange. Also assume that the

market for (i) XYZ stock is $55 1/4 - $55 1/2 (300 x 300), last sale at

$55 3/8, (ii) XYZ January 45 calls is $10 3/8 - $10 5/8 (10 x 5), (iii)

XYZ January 50 calls is $5 3/4 - $6 (80 x 40) and (iv) January 60 puts

is $5 - $5 1/4 (10 x 20), If a marketmaker, whether for XYZ stock or

options or both or neither, on the floor of the exchange, hears a block

243/ AMEX Letter, supra, n.90, at 39-41.

889

positioning firm inquiring of certain stock marketmakers as to their
interest in purchasing a portion of a large block of XYZ stock at a
price substantially below the last sale price, he may be able to anti-
cipate a drop in the price of XYZ. He may be able to profit from this
knowledge by accumulating a short position in the January calls and
a long position in the January puts. He may accumulate these positions
merely by bidding $5 or $5 1/8 for the XYZ January 60 puts and offering
XYZ January 45 calls at $10 5/8 or $10 1/2 and January 50 calls $6 or
$5 7/8. Moreover, if the marketmaker is not able to attract sufficient
interest by bidding or offering at existing prices or slightly improving
the market, he may also sell at the bid in the January 45 and 50 calls
or buy at the offer in the January 60 puts. Later, when the block trans-
action is executed and the price of XYZ is depressed, the marketmaker
may be able to close out his option positions profitably by making closing
purchases of the January 45 and 50 calls and closing sales of the January
60 puts.

Integrating the trading of options and their underlying securities
may also facilitate the manipulation of stock prices to protect and
make option positions profitable by allowing marketmakers to assess
the risks that may be associated with manipulative actively more
accurately. If side-by-side trading were permitted, for example,

890

an options marketmaker with a substantial short position of near
term at- or slightly out-of-the-money call options might more easily
sell stock short with the intention of preventing the stock from
"breaking through" the strike price if he were able to assess, due
to his presence on the floor and his resultant ability to observe
stock orders, transactions, and patterns of trading and quotations,
the buying interest for the stock in the crowd and on the book.

An example of manipulative conduct that might occur in a dual
marketmaking environment may further illustrate these points. Assume
that A is a specialist making simultaneous markets in XYZ stock
and options on the floor of an exchange that is the primary market
for XYZ and its related securities. Also assume that on June 1 (i) XYZ
opened at a price of $75, (ii) the July 70 calls were selling for $6
and the July 80 calls for $2, and (iii) A had a long position of 400
XYZ July 70 calls and 400 XYZ July 80 calls. To profit from the long
call positions, A might utilize his knowledge of the supply and demand in
the market for XYZ to cause the price of XYZ to move up a small amount
in a short time and might use his knowledge of the market for the XYZ
calls to liquidate the July 70s and 80s at a profit. Thus, A may quote
a market for XYZ of $74 7/8 bid and $75 1/8 offered after the market
opened, the $75 1/8 offered price reflecting A's own quotation and

891

offers at $75 1/4 being present on the book. If a market order to buy

200 shares of XYZ were to enter the market, A might sell 100 shares to

the customer from his inventory at $75 1/8, immediately raise his offer

to $75 1/4, and sell the remaining 100 shares to the customer from

the book at a price of $75 1/4. Subsequently, A might adjust his quotation

to $75 bid and $75 1/4 offered. If a market order to sell 300 shares

were to then come to the floor , A might purchase the shares at $75

if there were no orders on the book or in the crowd at that price

to assure that the bid price did not decline. As additional orders

to buy or to sell XYZ entered the market throughout the day, A might

continue to sell from the book until all book orders were filled at

a particular price, adjust his quotations upwards, and buy at the

bid price for his own account only to the extent necessary to assure

that the bid did not decline. As a result of this trading, the price

of XYZ might be raised to $76 at the end of the day and A might be

a net purchaser of XYZ. Assume, for the purposes of this example, that A

was net purchaser of 1500 shares at an average price of $75 1/2.

The following day, with A opening the market by quoting a bid
price of $75 7/8 and an offered price of $76 1/8, A might liquidate
his positions in the XYZ July 70 and 80 calls utilizing limit orders
that may be in the book, and orders that may be in the trading crowd.
The average premiums that A receives in this liquidation might be
$7 for July 70 calls and $2.50 for the July 80 calls. If A is also

892

able to later liquidate his 1500 share position in XYZ at an
average price of $75 1/2, again using limit orders in the book and
orders in the crowd, he would have obtained a $60,000 profit on his
option trading by causing a one point move in XYZ in one day. The
derivative nature of option pricing and the leverage characteristics
of options provide the dual marketmaker with the incentive to effect
the transactions described in this example. Access to the market
information in the limit order books and in the trading crowds for
the stock and its options may facilitate his activities. Of course,
the profitability of such conduct may depend upon the amount and price
of stock that must be absorbed to move the stock price as well as
upon the ability of the dual marketmaker to liquidate his option positions
while the stock price is at an artificially high level and his stock
positions without sustaining a loss that would significantly diminish
his option profits.

c. Potential Conflicts in Marketmaking Obligations
The transactions of stock and options marketmakers who are registered with
a national securities exchange are required to constitute a course of dealings
reasonably calculated to contribute to the maintenance of a fair and orderly
market, 244/ and such marketmakers may not enter into transactions or make

244/ See, e.g., CBOE Rule 8.7(a); AMEX Rules 170, 114(b) and 958(b); NYSE
Rules 104, 107B(2); MSE Article XXX, Rule 9, Article XLVII, Rule 6(a);
PSE Rule II, Sections 7(a), 9(g) and 10(d) Rule VI, Section 79(a)
and PHLX Rules 215, 1014(a). See also 17 C.F.R. 240.11b-l(a) .

893

bids or offers that are inconsistent with such a course of dealings. 245/
In addition, registered marketmakers generally have a "continuous
obligation to engage, to a reasonable degree under the existing cir-
cumstances, in deali-ngs for their own account when there exists, or it
is reasonably anticipated that there will exist, a lack of price continuity,
a temporary disparity between the supply of and demand for a particular
option contract, or a temporary distortion of the price relationships
between option contracts of the same class." 246/

Since specialists and marketmakers who are registered with a national
securities exchange have obligations to the markets for the securities in
which they are registered to deal for their own account, stock and options
marketmakers on an exchange floor may be required to assume similar obligations
with respect to both options and underlying securities in which they may
be making markets if the integration of stock and options trading is per-
mitted. 247/ This may create economic incentives and trading opportunities
for these marketmakers to engage in conduct that might be considered incon-
sistent with their obligations to one or the other market. For instance,

245/ Id.

246/ CBOE Rule 8.7(b). See also AMEX Rules 170 and 114(c); PHLX Rule 1014(f);
PSE Rule II, Sections 9(g) and 10(d), Rule VI, Section 79(b); MSE
Article XXX (Interpretation and Policies (.01)) Article XLVII, Rule
6(b); NYSE Rule 104.01, 170B(3).

247/ See, e.g. CBOE Plan, supra , n.6, Proposed Rules 8.7(a) and 8.7(b).

40-940 O - 79 - 59

894

were a marketmaker to acquire a substantial long position in a stock in
order to alleviate a temporary excess of supply over demand and to write
call options against that long position in order to hedge the position
partially, the writing activity might be viewed, if measured by traditional
standards, as inconsistent with the marketmaker' s obligations to the options
marketplace if supply in that marketplace also exceeded demand. 248/

248/ CBOE has summarized the potential conflict in marketmaking
obligations as follows:

Traditionally, a unitary market-maker (specialist)
in an auction market has been expected to trade for his
own account as needed to even out temporary disparities
in supply and demand (the so-called "affirmative"
obligation), but not to trade in such fashion as to
dominate or "lead" the market or destabilize it (the
so-called "negative" obligation). Since the supply
and demand balance for options generally tends to
parallel that for the underlying stocks, it is likely
that, by and large, a market-maker in stocks and a market-
maker in options would be dealing on the "same side" of
of the market in fulfilling these obligations. On the
other hand, particularly in an institutional market
with many block transactions, one who is a market-maker
in stocks alone would often want to hedge in the
options market — an "opposite side" transaction —
and an options market-maker likewise would want to
hedge in the stock market, in fulfilling their
respective obligations.

Side-by-side trading would not affect any of the
foregoing, but dual market-making could raise a serious
question of conflicting obligations * * * between [the]
possible obligation [of] a combined market-maker to have
simultaneous "same side" transactions in both markets
and his need to enhance his capacity in either market
by "opposite side" transactions in the other.

CBOE Letter, supra, n.87, at 24-25.

895

When evaluating proposals to integrate stock and options trading on
the exchange floor, the Commission should consider the extent to which
such integration may create incentives and opportunities for marketmakers
to engage in activity that may be deemed to conflict with their obligations
to the market for options or their underlying securities. Ultimately, the
Commission should determine whether marketmaking activities that may be
considered to be inconsistent with marketmaking obligations that may
arise in connection with integration proposals should be permitted, and,
if so, whether any inconsistencies that may result might be adequately
resolved, lessened, or regulated by means of surveillance, disclosure,
rulemaking, or otherwise.

It should be kept in mind, however, that certain forms of integration,
most probably including dual marketmaking, may not be feasible if marketmakers
are prohibited from engaging in transactions in an underlying security
or its related options if the transactions were, or could be deemed to
be, inconsistent with the marketmaker 's obligation to the market for either
security. In this regard, the Commission should consider the extent to
which marketmaking capacity for options or their underlying securities
may be reduced if marketmakers in an integrated environment were not permitted
to engage in transactions that may be deemed to be inconsistent with their
obligations to the market for either security.

896

d. Market Surveillance

The integration of trading in options and their underlying securities
may increase the difficulty of detecting improper trading practices
on an exchange floor. Additional market information and competitive
advantages, increased opportunities to engage in manipulative and other
improper activities, and potential conflicts in marketmaking obligations,
however, enhance the importance of conducting adequate market surveillance
in an integrated trading environment.

Market surveillance may become more difficult if further integration
of stock and options trading is permitted for two primary reasons. First,
much of the market information that may become a basis for making trading
decisions in an integrated environment may never be publicly disseminated 249/
and, at least partially as a consequence, may not be routinely available
for surveillance purposes. Unexecuted order information, indications
of buying and selling interest, and the presence of a broker working
a large order in a crowd are examples of such information. It is likely
that trading on the basis of this type of market information would be
more common if the trading of stocks and their related options were
further integrated, and the extent to which exchange surveillance programs
could be designed to monitor trading on the basis of such information
should be evaluated as integration proposals are reviewed.

249/ See discussion at 102-103, supra.

VJ7

Second, the ability to observe or otherwise obtain information
concerning orders, transactions, and patterns of trading and quotations
may permit stock and options marketmakers on exchange floors to more
continuously and more accurately assess the risks that may be associated
with improper trading conduct. 250/ Manipulations of stock prices to
benefit options positions, for instance, may be undertaken with greater
precision if a market participant on an exchange floor is able to evaluate
accurately the supply of and demand for a security by observing the buying
and selling interest in a trading crowd, the depth of orders on the book,
and the trading patterns of market participants at a trading post. Such
information may permit the effectuation of manipulative or other improper
actvities while buying or selling only the minimum amount of a security
necessary to accomplish the intended purpose. In fact, this information
may permit a market participant on an exchange floor to obtain the ends
he seeks merely by placing orders with a floor broker or specialist.
Since existing market surveillance systems often focus upon stock trans-
actions involving more than a predetermined number of shares, it may become
less likely that improper stock trading to benefit options positions will
be detected if such trading may be successfully accomplished with smaller

250/ See discussion at 102-105, supra,

898

and smaller amounts of stock. Moreover , to the extent that improper
ends can be achieved by means of orders, manipulative activity
may be even more difficult to detect because the exchanges do
not presently maintain and utilize for surveillance purposes records
of all orders that are entered on their floors and because the availa-
bility and completeness of order information varies significantly
among the exchanges. 251/

It should also be kept in mind that integrating the trading of options
and their underlying securities may create surveillance difficulties that
do not currently exist. For example, to prove that quote racing, tape
racing, or front-running occurred in an integrated trading environment, 252/
it may be necessary to prove the time that a quotation was given or the
time that a transaction took place rather than the time that the quotation
or transaction was entered into the price reporting system. 253/ It may
also be necessary to establish that a market participant had knowledge
of a stock quotation or transaction prior to the time of his option quotation
or transaction. Given the differences that may exist between the time

251/ See Chapter IV.

252/ See discussion at 108-111, supra,

253/ See Chapter IV.

899

that a quotation or transaction occurred and the time that it was
reported, 254/ it may be difficult to prove the required knowledge simply
by presenting evidence comparing the times that transactions or quotations
were entered into a price reporting system, particularly if a market
participant denies knowledge of the quotation or transaction that took
place first. In other words, as a practical matter integrating stock
and options trading may make it more difficult to determine precisely
who did what with whom at what time and who knew about it.

This is not to suggest that adequate market surveillance cannot be
conducted in an integrated trading environment. Rather, it is to emphasize
that the increased market information and competitive advantages, oppor-
tunities to engage in manipulative and other improper trading practices,
and potential conflicts in marketmaking obligation that may accompany
the implementation of plans to integrate the trading of options and
their underlying securities may, when coupled with the limitations of
existing surveillance information, make more difficult the task of monitoring
the markets for the securities being traded together. In light of the
Commission's obligation to assure that the exchanges "enforce compliance
by [their] members and persons associated with [their] members with the
provisions of [the Exchange Act]" 255/ and that the exchanges have rules

254/ See Chapter TV.

255/ Section 6(b)(1) of the Exchange Act [15 U.S.C. 78f(b)(l)].

900

designed "to prevent fraudulent and manipulative acts and practices,
to promote just and equitable principles of trade, * * * and, in
general, to protect investors and the public interest," 256/
the Commission should specifically consider the adequacy of surveillance
programs that exchanges proposing to integrate the trading of options
and their underlying securities would use to monitor such trading.

3. The Extent of Integration
Proposals to integrate the trading of options and their underlying
securities may contemplate various forms and degrees of integration.
Integration may occur with respect to the physical environment in which
trading would occur as well as with respect to the performance of market-
making functions. For instance, integration plans that would allow
specialists and marketmakers to trade options and their underlying
securities while maintaining the physical separation between stock
and options trading floors and a strict separation of stock and option
marketmaking functions may involve the least amount of integration. 257/

256/ Section 6(b)(5) of the Exchange Act [15 U.S.C. 78f(b)(5)l.

257/ It should be kept in mind that options specialists and market-
makers are already permitted to trade underlying securities
without restriction and that stock specialists and registered
stock marketmakers on secondary exchanges are not restricted
in their ability to trade options. See discussion at 94-95,
supra.

901

On the other hand, integration proposals that contemplate trading
options and their underlying securities at the same physical location
and simultaneous marketmaking in all related securities by an individual
or firm would involve the highest degree of integration.

Between these ends of the spectrum, a wide variety of integration
plans may be designed involving varying modes of integration. It may
be feasible, for example, to remove physical barriers between stock
and options trading floors without permitting (i) the trading of these
securities at the same physical location, (ii) the trading of options
by stock specialists or registered stock marketmakers , or (iii) the integration
of marketmaking functions. Plans may also be designed to allow the trading
of options and their underlying securities at the same physical location
while maintaining existing restrictions concerning (i) stock specialist
and registered stock marketmaker options trading and (ii) the integration
of marketmaking activities. In addition, proposals may be submitted which
would permit (i) the trading of options and their underlying securities at
the same physical location, and (ii) stock specialist and registered stock
marketmaker options trading, but would continue to separate stock and
options marketmaking functions. Involving a still higher degree of integration,
plans may contemplate (i) trading options and their underlying securities
at the same location, (ii) trading in all related securities by all market
participants, (iii) marketmaking in all related securities by a specialist
or other marketmaking firm, but prohibiting simultaneous marketmaking
in options and their underlying stocks by an individual.

902

These examples are not intended to, and of course do not, exhaust
the possible forms that integration proposals may take. Rather, they
have been provided to place the integration proposals that have already
been made in perspective with regard to the degree of integration that
they would entail. 258/ The form and degree of integration is an important
factor to consider because the extent of improvements in the quality
of markets and the severity of regulatory concerns that may result
from such proposals may vary directly with the extent of integration
proposed. The quality of the markets for options and their underlying
stocks may improve in direct proportion to the extent that integration
is permitted because each step that is taken toward complete integration
may enhance the ability of stock and options specialists and marketmakers
to limit the risks associated with their marketmaking activities,
to obtain more complete information concerning the supply of and demand
for related securities, and to act upon such information quickly.
This, in turn, may increase the ability of these marketmakers to make
deeper and more liquid markets. In addition, the greater the degree

258/ The CBOE Plan contemplated a complete integration of stock and options
trading. See discussion at 97-98, supra. The NYSE concurrent trading
proposal may, by comparison, result in a far lesser degree of integra-
tion. See discussion at 96, supra, and 145-147, infra. The secondary
stock exchange proposals to remove the physical barriers between
stock and options trading floors and to permit individuals to hold
simultaneous marketmaker appointments in options and their underlying
securities involve degrees of integration between those proposed
by CBOE and NYSE. See n.8, supra .

903

of integration that is permitted, the greater the operational efficiencies
that may result to retail firms and other market participants. At the
same time, however, each step that is taken toward integrating the trading
of options and their underlying securities may (i) provide more market
information and competitive advantage to more market professionals on
exchange floors, (ii) increase the opportunities to engage in manipulative
and other improper trading conduct, (iii) increase the potential for conflicts
in marketmaking obligations, and (iv) make effective market surveillance
more difficult.

4. Characteristics of the Exchange
The characteristics of the exchange proposing to integrate the trading
of options and their underlying securities may also directly impact upon
the extent of improvements in market quality and the severity of the
regulatory concerns that may result from integration. The role
of the exchange making the integration proposal in the markets for the
securities that would be subject to the proposal should be considered
when any integration proposal is evaluated. More specifically, whether
the exchange is the primary market for the securities involved, 259/ and,
if so, the extent to which it is able to attract more order flow than
competing markets may be relevant considerations. In addition, the type
of marketmaking system that the exchange uses, the extent of marketmaking

259/ See n.lll, supra.

904

competition on the exchange floor, and the exclusivity of access to the
limit order book on the exchange involved are factors that should be taken
into account.

a. Primary and Secondary Exchanges
Since the primary exchange for an underlying security attracts more
orders and is responsible for more volume in that security than any other
market, it is likely to be the source of more material market information
about that security than any other market. A more complete picture of
the supply of and demand for an underlying security should be found on
a primary stock exchange because, by definition, more transactions occur
there than on other markets and because correspondingly more orders are
likely to be sent there. The larger the percentage of total volume and
order flow for an underlying security that a primary stock exchange is
able to attract, the more likely it may be that that exchange will become
an essentially exclusive reservoir for market information that might
influence the price of the underlying stock. On the other hand, because
options prices are generally based upon the price of the underlying stock,
the primary exchange for an option class will, under most circumstances,

905

contain less market information that may effect stock, and consequently
options, prices than the primary stock market. 260/

In light of the quality and quantity of market information that may
be present at a primary stock exchange, integrating the trading of options
and their underlying securities on such an exchange may result in greater
improvements in stock and options market quality than may be obtainable
on other exchanges. In addition, improvements in market quality that
may result from integrated trading on a primary stock exchange may increase
in direct proportion to the market share that such an exchange enjoys
with respect to the underlying securities that are subject to integrated
trading. At the same time, however, integrated trading on a primary stock
exchange may (i) increase the market information and competitive advantages
for market professionals on the floor of that exchange, (ii) create additional

260/ This is not to suggest that secondary stock markets and primary and
secondary options markets may not, at a particular moment, contain
market information that may be relevant to the supply of and demand
for an option or its underlying security. The execution of a
large stock order on a secondary stock exchange, for example, may
effect the price of that stock in all markets, and secondary
stock exchange specialists may obtain indications of buying and
selling interest in multiply traded stocks before transactions
occur and before such information is known to other market
participants. Similarly, options specialist and marketmakers
will always have significant market information about the options
they are trading due to their presence on an options exchange
floor and may become aware of combined stock and options orders
or imbalances in the supply of and demand for an options series
that may suggest that changes in the price of an underlying
security are going to occur.

906

opportunities to engage in manipulative and other improper trading
activities, and (iii) make the monitoring of trading more difficult than
would be the case on other exchanges. Moreover, the severity of these
regulatory concerns may increase as the market share of the primary stock
exchange increases.

On the other hand, since market participants on the floor of a
secondary stock exchange will continue to depend heavily upon publicly
disseminated quotation and transaction information from the primary
stock exchange when making stock and options pricing decisions, improvements
in market quality that may result from integration on such an exchange
may be minimal and in direct proportion to the amount of underlying
stock order flow that the exchange can capture. A secondary stock
exchange that is also a primary options exchange, however, may be better
able to improve the quality of its options markets than a secondary
stock exchange that is also a secondary options exchange. These improvements
may be obtained because options trading arid quotation patterns and the
presence of, and ability to execute, combined stock-options orders on a
primary options exchange may provide marketmakers on such an exchange with
more complete information than they currently have with regard to the
markets for underlying securities, may enhance their ability to anticipate
changes in the supply of and demand for a stock and to react to such

907

changes in market conditions more swiftly, and, as a consequence, may
permit them to more accurately assess and adjust the risk of their trading
activities. But again: to the extent that improvements in market
quality can be achieved on a secondary stock exchange, whether such
exchange is a primary or secondary options exchange, the severity of
the regulatory concerns may be enhanced.

b. The Marketmaking Systems

Proposals to integrate the trading of options and their underlying
securities may contemplate that marketmaking functions for the securities
subject to the integration program will be performed by a unitary specialist, 261/
competing specialists, a group of competing marketmakers, 262/ or some
combination of these systems. While it is difficult, if not impossible, to
project or compare, in the absence of integrated trading experience, the
potential that each of these marketmaking systems might have for improving
market quality, the regulatory concerns that each system may inspire will
clearly vary in nature and in scope.

A unitary stock specialist, for example, may already enjoy substantial
market information and competitive advantages over other market participants.

261/ A unitary specialist may be an individual or a specialist unit. A
specialist unit is a firm or other group of individuals that assumes
responsibility for making markets in a single security or in a set
of related securities.

262/ It should be noted that the CBOE Plan contemplated the implementation
of a competing marketmaker system for stocks as well as options. See
n.228, supra.

908

Such a specialist may have an "intimate knowledge of the past market action
of the stocks in which he specializes." 263/ In addition, he may have
"sole access to the specialist book showing outstanding orders both below
and above the market" for his stocks 264/ and may derive substantial
income for executing book orders as an agent. 265/ Further, as "the heart
of the exchange market mechanism," 266/ a unitary stock specialist may
be exposed to a constant flow of orders, inquiries, and trading in the
trading crowd for his specialty securities. Together, these factors may

263/ SEC, Staff Report on Organization, Management, and Regulation of
Conduct of Members of the American Stock Exchange, at 23 (1962),
quoted in Special Study, supra , n.63, at 59.

264/ Id. With respect to the predictive value of the specialist's limit
order book, for instance, it has been observed:

The specialist's book has an importance beyond that of
a mere repository of unexecuted agency orders. It serves
as an indicator of public interest in a particular security.
For example, a book containing many orders reasonably close
to the market indicates that, at the time, the stock is an
active one of wide interest. On the other hand, a light
book may indicate that a stock is less active, or that if
active, it may be volatile in character. * * * A book
that has a great many sell-stop orders suggests that the
stock will suffer a quick decline when these orders are
reached. In addition, a large number of limit orders
immediately below or above the market may indicate that,
in the very short run, there is a floor or ceiling to the
stock's price.

Special Study, supra, n.63, at 76.

265/ Concerning the portion of total specialist income that is derived
from the execution of agency orders, see CBOE Letter, supra, n.87,
at 34 and Table D.

266/ Special Study, supra, n.63, at 59.

909

permit a unitary specialist to assess market conditions and anticipate stock
price movements and temporary imbalances in the supply of and demand for his
specialty securities more accurately than other market participants. With
this market information and the ability to adapt to shifting market conditions
instantaneously and prior to the public dissemination of transaction or
quotation information reflecting such shifts, the competitive advantages
that a unitary stock specialist possesses may be numerous and significant. 267/

267/ In fact, in many circumstances, a specialist may have "the power to
set and control [stock] prices, unilaterally." Special Study, supra,
n.63, at 142, 136-142. As the Special Study pointed out and
illustrated with reference to NYSE's unitary stock specialist system:

Even in providing price continuity specialists' trading
affects the balance that would otherwise result from the
free play of public supply and demand. But the impact of
specialists' activities on the market goes beyond this.
To an extent not generally realized, the market on the
NYSE is a "dealer's market" in which the specialist can
at various times set and control the prices of a security.

This is particularly true in inactive stocks with thin
books and few public orders. In these, the specialist
acts as dealer in most transactions * * * and thereby
sets the prices at which buyers and sellers trade. A
specific example of this was observed by a member of
the Commission staff on the floor of the Exchange. The
specialist in an inactive stock had an order on his
book to sell 200 shares at 84 1/2. The last sale of
the stock had been at 84. A broker left the specialist
a market order to buy 2,000 shares, and the specialist
thus became the buyer's agent. The specialist decided
to execute 1,000 shares of the market order by selling
that amount for his own account at 84; he then executed 200
shares against the limit order at 84 1/2. Next the
specialist decided to sell another 800 shares for his
own account at 85, setting the price that the buyer paid.
When the commission firm's broker returned to confirm

(footnote continued on next page)

40-940 O - 79 - 60

910

Integrating stock and options trading may provide a unitary stock
specialist with additional market information and competitive advantages.
Information that he may ascertain from the options markets as a result
of integration may enable him to assess better the supply of and demand
for his specialty stocks and at the same time to anticipate price movements
more accurately. To the extent that integration permits a unitary stock
specialist to engage in options trading based on the market information
that he has obtained during the course of performing his specialist
functions, the competitive advantages of such a specialist will be
further enhanced. If, for instance, a unitary stock specialist is
permitted to trade options on the basis of his knowledge of the contents
of a stock limit order book to which he alone has access, indications
of buying or selling interest or unexecuted orders in his stock trading
crowd, or stock quotation or transaction information that has not been
publicly disseminated, the competitive advantages that such a stock specialist

(footnote continued)

the transaction, he brought with him an order to sell
1,000 shares of the same stock at the market. In this
instance the specialist purchased the stock at 84 1/2 for
his own account, a half point beneath the last sale.
Although the broker involved had the right (and duty) to
negotiate a price at arm's length, the inactivity of the
stock and the size of the order gave the specialist broad
discretion to set the prices at which these orders would
be executed.

Id., at 136.

911

may have, in the markets for his specialty stocks as well as in the markets
for related options, may increase substantially in relation to those that
other market participants enjoy and that he now possesses.

Allowing a unitary stock specialist to use market information obtained
in the performance of his specialist obligations as a basis for options
trading may also present questions concerning the fairness of the securities
markets. It might be deemed unfair, for example, if a unitary stock
specialist with exclusive access to a stock limit order book were to
purchase call options primarily because his stock limit order book indicated
a temporary excess of demand over supply. While on the one hand the
specialist might maintain that he anticipated that he would be called upon
to supply stock and sought to hedge his projected stock sales by purchasing
calls at advantageous prices, on the other his trading was based upon
market information that other participants in the options markets did
not have. Further, if some of the specialist's customers who had left
stock purchase orders on his book were also purchasing call options on
that stock, their orders to purchase options may be competing with the
specialist's orders to purchase options even while the specialist was
acting as the agent of these customers. Whether this or similar situations
would amount to "undue advantage" 268/ or is justified by the "uses" 269/

268/ Special Study, supra, n.63, at 14.
269/ Id.

912

and "contributions" 270/ that a unitary stock specialist makes to the
marketplace should be considered in connection with all integration
proposals involving unitary stock specialists.

Integrating trading in options and their underlying securities may
also provide a unitary stock specialist with additional incentives and
opportunities to manipulate securities prices or to engage in other improper
trading practices. To the extent that such a specialist is permitted to
maintain options positions and to trade options on a regular basis, for
example, he may have incentives to influence stock prices to benefit these
positions. The derivative nature of option prices and the leverage
inherent in options trading may be the primary sources of these incentives
while the market information and competitive advantages of the specialist
may provide him with opportunities and the ability to engage in improper
conduct with minimal risk of loss or detection. 271/ In this connection,
it must be kept in mind that profits may be derived from options positions
as a result of relatively small movements in the price of an underlying
stock, 272/ and that, at the same time, it is the "prosaic quarter and

270/ Id.

271/ See, e^cj., discussion at 107-114, and 118-122, supra.

272/ See discussion at 107-114, supra.

913

half-point price changes" 273/ which occur relatively frequently that

"provide the floor professional with the routine opportunity to gain

a trading advantage." 274/

The potential conflicts in marketmaking obligations may be most acute

when a unitary stock specialist is involved with an integrated trading

proposal. As CBOE has observed:

The question [of conflicting marketmaking obligations]
is more theoretical than real where there is an
effective competing market-maker system, because
the affirmative obligation is there a shared one
and, in any case, temporary disparities in supply
and demand tend to be evened out by diverse strategies
and judgments among the various marketmakers themselves.
With a unitary specialist system and an exclusive book,
on the other hand, the quality of performance of the
affirmative obligation is dependent on a single
specialist, and his ability and willingness to per-
form at highest levels in either stock or options
market may depend on his ability to hedge in the other
market. The already built-in conflict in the
specialist's combined dealer-agency role may thus
be seriously aggravated by the conflict between
his possible obligation as a combined market-maker
to have simultaneous "same side" transactions in
both markets and his need to enhance his capacity
in either market by "opposite side" transactions
in the other. 275/

273/ AMEX Letter, supra, n.90, at 41.

274/ Id.

275/ CBOE Letter, supra, n.87, at 25. See also discussion at 114-118,
supra.

914

It may appear, on the other hand, that surveillance tasks may
be facilitated by the presence of a unitary stock specialist in an
integrated trading environment since it may be easier to monitor the
trading activities of a single specialist than of a group of competing
marketmakers. Experience may prove this impression mistaken, however,
since (i) the quantity and quality of the market information that
such a specialist may possess, (ii) the relatively small stock price
movements that may be necessary to make ootions positions and trading
profitable, (iii) the possibility that such a specialist may obtain
improper ends using small amounts of stock, and (iv) the numerous
alternative economic explanations that may be given for particular
trading activities, 276/ may combine to make the detection of trading
improprieties in which a unitary stock specialist may engage extremely
difficult 277/ and to frustrate successful enforcement of the securities
laws in the event that an impropriety is suspected. Moreover, adequate
market surveillance of a unitary stock specialist's trading in an
integrated environment could only be conducted if surveillance information
relating to each of that special ist°s stock and options orders and
transactions, as well as his positions in all related securities,
were available for surveillance purposes and reviewed on a daily basis.

276/ See Chapter III and Chapter IV.
277/ See discussion at 118-122, supra.

915

Were a competing stock marketmaker system, as CBOE has proposed, 278/
to be involved in an integration proposal, the regulatory concerns may be
less acute. Because stock inquiry and order flow may be dispersed among
numerous competitors, the market information and competitive advantages
of each marketmaker may be significantly less than those that may accrue
to a unitary specialist. Further, if agency and dealer functions are separated
and the stock limit order book is shared, competing stock marketmakers
would not have the market information and brokerage income advantages
associated with a unitary stock specialist's exclusive access to his limit
order book. With lesser market information and competitive advantages
and the presence of numerous competitors of relatively equal stature on
the same exchange floor, a competing stock marketmaker system may present
less opportunities to engage in manipulative activities and less potential
for conflicts in marketmaking obligation than a unitary stock specialist
system. 279/ Fairness concerns and the adequacy of market surveillance
programs, however, may not be of lesser magnitude solely because a competing
stock marketmaker system is proposed as part of an integration plan.

278/ See n.228, supra.

279/ See discussion at 129-135, supra.

916

The severity of regulatory concerns associated with the options market-
making systems that an integration plan contemplates may similarly vary
in accordance with whether a unitary specialist or competing marketmaker
system is intended. 280/

B. Conclusions

1. The Gradual Approach
Proposals to integrate the trading of options and their underlying
securities may take a wide variety of forms and involve a broad range of
significant variables. Each proposal will be submitted from its own
circumstances and at its own time, and each should be considered within
this context. Because the securities markets are constantly evolving,
issues concerning the extent to which stock and options trading should
be integrated on an exchange floor should be addressed as they are presented
and resolved within their particular confines. Integration decisions should

280/ It must be kept in mind, however, that even while unitary

options specialists and competing options marketmaker have market
information and competitive advantages of their own, the derivative
nature of the options markets may strictly limit the significance
of these advantages in relation to the advantages of unitary stock
specialists and registered stock marketmakers. Stated differently,
because stock prices largely determine the prices of related options,
market information concerning the supply of and demand for a stock
may be substantially more valuable than information concerning the
supply of and demand for options on that stock. Thus, while unitary
stock and options specialists, as well as registered stock and competing
option marketmakers, may have comparable market information and
competitive advantages, their advantages are comparable only in kind
and not in quality or value.

917

be made on a case-by-case basis and with a clear understanding that short-
term and long-term answers to integration questions may be very different.

2. Principles of General Applicability and the Statutory
Standards

Integration decisions, however, will generally require consideration
and balancing of the same basic factors. On the one hand, integration may
result in improvements in the liquidity, depth, and efficiency of the securities
markets. On the other hand, it may provide market participants on exchange
floors with additional market information and competitive advantages and new
incentives and opportunities to engage in improper trading practices while
creating potential conflicts in the marketmaking obligations of these
market participants and increasing the difficulties of conducting adequate
surveillance of the integrated markets. Thus, the essential balancing to
be performed in connection with a review of integration proposals is the
extent of expected improvements in market quality against the anticipated
severity of accompanying regulatory concerns.

Both sides of this balance will be directly affected by two factors:
The extent of the integration that is proposed and the characteristics of
the exchange that has made the integration proposal. With respect to the
character of the exchange submitting an integration plan, the competitive
position of that exchange and the marketmaking systems that it intends to
use upon implementing its integration program will directly influence the
weight of the balance. As a consequence, these factors should be taken
into account when integration proposals are evaluated.

918

The way in which these factors are likely to interact during the balancing
process may be described with four principles of general applicability:

1. To the extent that improvements in market quality
or efficiency that are expected to be derived from an inte-
gration plan will result from permitting members on the floor
of one exchange to have market information and competitive
advantages that exceed those available to other market parti-
cioants, the magnitude of regulatory concerns that may accompany
implementation of the proposal is likely to increase. This

is because the regulatory concerns result orimarily from the
market information and competitive advantages that market
participants on an exchange floor possess.

2. The greater the degree of integration that is
proposed, the more opportunity there may be to obtain im-
provements in market quality or efficiency. At the same
time, however, regulatory concerns are likely to become more
acute as the degree of integration increases and to the extent
that the first principle comes into play.

3. Because a primary stock exchange contains more
material market information concerning stock prices than
any other market, and since options prices are largely
derivative from these prices, improvements in market
quality or efficiency that may result from integration
are likely to be most significant if integration occurs
on the primary stock exchange. For the same reason,
regulatory concerns are likely to be most serious on
that exchange to the extent that the first principle
becomes operative. In addition, the larger the per-
centage of stock volume and order flow that the primary
stock exchange is able to capture with respect to stocks
that are subject to its integration plan, the more
material market information is likely to be present

on that exchange and, consequently, the greater the
potential improvements in market quality or efficiency
and the potential seriousness of regulatory concerns.

4. Regulatory concerns are likely to be of greatest
magnitude if integrated trading is permitted on an
exchange that uses a unitary specialist stock marketmaking

919

system in which the unitary specialist performs both
principal and agency functions and has exclusive access
to, and knowledge of, the stock limit order book. The
rationale for this principle is the same as the rationale
for the first principle.

As these principles are applied and specific integration proposals are

reviewed, the requirements of the Exchange Act should be kept in mind.

Decisions regarding these proposals should be consistent with the development

of a national market system, 281/ the maintenance of fair and orderly markets, 282/

the public interest, 283/ the protection of investors, 284/ fair competition

among brokers and dealers and among exchange markets 285/ economically

efficient execution of securities transactions, 286/ and the practicability

of brokers executing orders in the best market. 287/ In addition, when

making integration decisions, the Commission should assure that an exchange

281/ See, e^. , Sections 2, 6(b)(5), 15A(b)(5) and 19(b)

of the Exchange Act [15 U.S.C. 78b, f (b)(5), and s(b)].

282/ See, e^g., Sections 9, 10, and HA(a)(l)(C) of the Exchange Act
[15 U.S.C. 78i, j, k-l(a)(l)(C)].

283/ See, e.g., Sections 6(a), HA(a)(l)(C) and 15A(c) of the Exchange
Act [15 U.S.C. 78f(a), k-l(a)(l)(C) and o-3(a)].

284/ Id.

285/ Section HA(a)(l) of the Exchange Act [15 U.S.C. 78k-l(a) (1)] .

286/ Id.

287/ Id.

920

seeking to implement an integration proposal would have the ability to
enforce compliance by its members with the Exchange Act in an integrated
trading environment and that exchange rules would be designed to prevent
fraudulent and manipulative practices 288/ and to promote just and equitable
principles or trade. 289/ Further, the Commission should assure that imple-
mentation of an integration plan that would not impose unnecessary or
inappropriate burdens on competition. 290/

3. The Principles Applied
Application of the integration principles provides some insights with
respect to integration proposals such as those that the exchanges have
made. Ihe PSE and PHLX proposals to eliminate the physical barriers between
their stock and options trading floors and the PSE and MSE proposals to
permit registered stock marketmakers or alternate stock specialists
to hold simultaneous marketmaker appointments in options and their underlying
securities, for example, involved secondary stock exchanges that attract
a small percentage of total stock volume and order flow. In fact, in 1977,
PSE captured only 3.57 per cent, PHLX 1.40 per cent, and MSE 4.74 per cent

288/ See Section 6(b)(5) and 15A(b)(6) of the Exchange Act [15 U.S.C.
78f(b)(5) and o-3(b)(6)] .

289/ Id.

290/ See Sections 6(b)(8), 15A(b)(9), 19(b) and 23(a)(2) of the Exchange
Act [15 U.S.C. f(b)(8), o-3(b)(9), and w(a)(2)].

921

of the total consolidated taDe volume for common stocks traded on more
than one exchange. 291/ In light of the small amount of stock order flow
that these exchanges presently obtain, they may hold only minimal potential
for improving market quality or efficiency by means of integrating their
stock and options trading. However, regulatory concerns at these exchanges
may be of relatively small magnitude because market information and
competitive advantages that marketmakers on these exchange floors might
obtain as a result of integration may be minimal. Moreover, insofar as
these prooosals contemplate that trading in options and their underlying
stocks will not occur at the same trading post and that stock and options
marketmaking functions will remain separated for stock specialists,
they do not contemplate a complete integration of stock and option trading.
As a result, the opportunities for improving market quality or efficiency
and the extent of regulatory concerns may be less than would otherwise
be the case. 292/ On the other hand, because each of these exchanges is also
the primary options exchange for options classes that it lists exclusively,

291/ NYSE, 1977 Annual Report of the Quality of Market Committee,
Exhibit E. See also Table 22.

292/ This conclusion is not meant to suggest that integrated stock and
options trading should be permitted on secondary stock exchanges.
Indeed, as AMEX has suggested:

(footnote continued on next page)

922

allowing these exchanges to integrate the trading of these options and
their underlying securities may enhance the quality or efficiency of the
markets for these options classes and their underlying securities on these
exchanges while concomitantly raising certain regulatory concerns.

NYSE's proposal to permit its stock specialists to trade options
with respect to their specialty stocks and registered stock marketmakers
to trade options for their own account presents far different concerns.
During the first half of 1978, NYSE's median share of the total consolidated
volume for stocks on which listed options were traded was 86.14 per cent. 293/
NYSE also uses a unitary specialist system of stock marketmaking in which

(footnote continued)

The proposals to integrate options and equity
trading on certain of the regional exchanges * * *
should * * * be approached by the Commission with
extreme caution. Protection of investors and
maintenance of public confidence in the fairness
of our markets should be paramount in any consideration
by the Commission of proposals which might give
floor professionals advantage over other market
participants.

While the need for a barrier between options and
equities trading rooms on the regional exchanges may be
of less concern than would be the case on the primary
market for underlying stocks, we still believe such
a requirement should be retained if for no other reason
than to avoid even the appearance of unfair trading
advantages being granted to floor professionals.

AMEX Letter, supra, n.90, at 46.

293/ Letter to Richard Weingarten, Special Counsel, Special Study of the
Options Markets, from James W. Fuller, Senior Vice President, NYSE,
dated August 21, 1978.

923

principal and agency functions are combined and the specialist has
exclusive knowledge of, and access to, the limit order book. Accordingly,
regulatory concerns are likely to be most severe, in absolute terms and
relative to those that integration may cause on any other exchange, in
the context of any NYSE proposal to integrate stock and options trading
under existing conditions. By the same token, however, improvements in
market quality or efficiency that may be obtained as a result of integration
are likely to be most substantial, again in both absolute and relative
terms, if integration takes place on NYSE under present circumstances.

The extent of integration that the NYSE concurrent trading proposal
contemplated, however, was minimal. While seeking to allow NYSE specialists
to trade options on their specialty stocks and NYSE registered stock
marketmakers to trade options for their own accounts, the proposal would
not have involved integration of stock and options marketmaking functions
or the trading of options and their underlying securities at the same
Physical location on the NYSE floor. 294/ The practical result of the

294/ Indeed, NYSE has recently stated that it does "not now contemplate
[side-by-side] trading or dual market-making" in any form and
characterizes its plans as follows:

Our present plan is to trade options in a room physically
separated from the equity trading floor, rather than to
trade options side-by-side with their underlying stocks
* * *. Moreover, we would want to gain actual experience
with options trading before making any firm decision
on the desirability of "dual marketmaking" -i.e.,
simultaneous market-making in a stock and its related
options by the same person, or by different persons
associated with the same firm.

NYSE Letter, supra, n.85, at 1. But see discussion at 207, 225-226,
infra.

924

proposal would have been that NYSE stock specialists and registered
stock marketmakers, like all other market participants who are not primary
stock exchange soecialists or marketmakers, would have been able to trade
listed options on one exchange floor and their underlying securities on
another. Because such a proposal would not entail a substantial degree
of integration, regulatory concerns associated with it, while still
quite serious, may be of lesser magnitude than those that may accompany
other forms of integration that NYSE might propose.

It should be noted, however, that the NYSE concurrent trading proposal
does not represent the least extent of integration that could be proposed.
Indeed, numerous proposals were made in response to the Commission's
release announcing its review of the prohibitions on stock specialist
and floor trader options trading 295/ which would have permitted these
market participants to engage in options trading only for "legitimate
hedging" purposes. If an NYSE concurrent trading proposal were to contain
such a limitation, the extent of integration that the proposal would
be reduced and the severity of regulatory concerns that may be associated
with the proposal may be lessened. Accordingly, NYSE and the
Commission may wish to explore the feasibility of designing a workable

295/ Securities Exchange Act Release No. 10312, supra, n.219.

925

and monitorable 296/ definition of "legitimate hedging" as part of any
concurrent trading proposal that NYSE may submit. 297/

296/ Effective monitoring of NYSE stock specialist and registered
stock marketmaker stock and options trading would, of course,
require regular reporting of stock and options positions, trans-
actions, and orders for these market professionals. Such reports
may be necessary on a daily basis and should contain the time
that each stock and options order was entered, executed, and
a report of execution was received. Without such information,
it would seem to be impossible to determine whether particular
orders were entered or transactions occurred for heding purposes.
See, e.g. , proposed MSE rule concerning "bona fide hedging," n.297,
infra, at (c).

297/ The task of establishing a workable and monitorable definition of
"legitimate hedging" is not an easy one. Commentators, however,
have already proposed three possibilities, each of which is
presented below. These proposals are set forth to demonstrate
the types of definitions that may be devised and not to suggest that
they are exclusive, correct, or the most viable for concurrent
trading purposes.

1. MSE proposed the following rule and definition of a
"bona fide" hedge:

"(b) A member or member organization acting as
a specialist, co-specialist or relief specialist
(a "Specialist") may purchase and sell options
issued by a registered clearing agency to establish
a bona fide hedge of his position (net of any
position in an investment account) in a stock in
which he is a specialist (a "Specialty Stock").
An options position constitutes a bona fide hedge of a
stock position if the options position was acquired for
the purpose and is reasonably anticipated to have the
effect of offsetting, in whole or in part, an adverse
change in the market value of the stock position. A
Specialist holding an options position in a Specialty
Stock has the burden of demonstrating that his options
position constitutes a bona fide hedge of his stock
position.

(footnote continued on next page)

40-940 O - 79 - 61

926

V. AN OVER-THE-COUNTER MARKET FOR STANDARDIZED OPTIONS

The NASD submitted a proposal to permit the display and insertion
of quotations with regard to qualified and approved standardized options

(footnote continued)

"(1) A bona fide hedge may consist of long
positions, short positions, or a combination of
both, in which event it is the reasonably anticipated
net price change of all option contracts in the
combined options position that is relevant to whether
that position is a bona fide hedge of a stock position.

"(A) A long stock position ordinarily may be hedged
by (i) a short position in call options, (ii) a long
position in put options, or (iii) a combination of long
and short positions in call options, put options, or
both such that a decrease in the market value of the stock
position caused by a downward change in the price of the
stock is reasonably anticipated to be offset, in whole
or in part, by a net increase in the market value of all
options contracts held in such combined position. A
long stock position may not be hedged by a long position
in call options or a short position in put options,
unless such position is held in combination with other
options positions meeting the condition of (iii) above.

"(3) A short stock position ordinarily may be hedged
by (i) a long position in call options, (ii) a short position
in put options, or (iii) a combination of long and short
positions in all options, put options, or both such that
a decrease in the market value of the stock position caused
by an upward change in the price of the stock is reasonably
anticipated to be offset, in whole or in part, by a net
increase in the market value of all options contracts
held in such combined position. A short stock position
may not be hedged by a short position in call options
or a long position in put options unless such position
is held in combination with other options positions meeting
the condition of (iii) above.

(footnote continued on next page)

927

(: NASDAQ options") on the NASDAQ securities quotation system. As

is the case for all standardized options, the OCC would be the issuer

(footnote continued)

"(2) Under no circumstances may a Specialist
establish an options position in a Specialty Stock
unless the stock position to be hedged thereby is
established and a report of each transaction giving
rise to that stock position has been displayed on the
Consolidated Transactions Tape or is available through
an interrogation system. If an options position ceases
to serve as a bona fide hedge of a stock position,
either because it no longer may be reasonably anticipated
to offset to any degree an adverse change in the market
value of the stock position, or because the stock position
has been liquidated, the options must be liquidated as
promptly as oracticable.

"(c) Each specialist shall weekly file with the
Exchange, in such form as the Exchange shall prescribe,
a written report respecting his position at the end
of, and his transactions during, that week in options
in each Specialty Stock.

Letter to Sheldon Rappaport, Associate Director, Division of Market
Regulation, of the Securities and Exchange Commission, from Michael
E. Tobin, President, Midwest Stock Exchange, (undated), at Exhibit
A, d. 3 (File No. S7-490).

2. An NYSE stock specialist, on the other hand,
suggested that stock specialists and floor traders should
be permitted only to hold options as hedges on the "opposite
side" of the market with respect to stocks in which such
market participants hold a position. "Cpposite side"
transactions refer to selling calls or buying puts
against a long stock position, or buying calls or selling
puts against a short stock position because stock price
movements will effect these positions in an offsetting
manner. This specialist also suggested that the use of
options to hedge should be permitted only when a stock
position exceeds 5000 shares and only if the call options
are purchased or put options are sold that cover no greater
number of shares than the position in the underlying security.

(footnotes continued next page)

928

and primary obligor of NASDAQ options, and such options would be stan-
dardized as to exercise price, expiration date and unit of trading. 298/

(footnote continued)

Letter to Ronald F. Hunt, Secretary, Securities and Exchange Commission,
from Spear, Leeds & Kellogg dated September 26, 1973 at 1 (File No.
S7-490).

3. In connection with the margin treatment of marketmaker
hedging transactions, CBOE has proposed that a "bona fide hedge"
might be defined in terms of a mathematical formula essentially
derived from the Black-Scholes options pricing model. As
CBOE has stated:

Under a formula of this type, it is possible to
estimate the rate of change in the price of an
option with respect to small changes in price in
the underlying stock — the estimate of the amount
by which an option price would change upon a
change of $1.00 in the stock price is commonly called
the "dollar delta" and thus determine the amount
of stock that would theoretically hedge a total
options position against small changes in the price
of the stock.

Letter to Robert S. Plotkin, .Assistant Director, Office of Saver and
Consumer Affairs of the Board of Governors of the Federal Reserve
System, from Joseph W. Sullivan, President, CBOE, dated November 16,
1976, at 4. See also Letter to the Secretary of the Board of
Governors of the Federal Reserve System, from Joseph W. Sullivan,
President, CBOE, dated January 24, 1977, at 45-46, and discussion in
Chapters II and VII supra.

298/ NASD Plan, supra , n.90. The Plan would require that securities under-
lying qualified and approved NASDAO options be registered pursuant to
Sections 12(b), 12(g)(1), or 12(g) (2) (6) of the Act [15 U.S.C. 781(b),
(g)(1), and (g)(2)(6)]. The Plan also required that the issuer of
the underlying securities be in compliance with Sections 13 and 14
of the Act [15 U.S.C. 78m, n] and, among other things, have a net
income, after taxes but before extraordinary items net of tax effect,
of at least $1,000,000 in each fiscal year in three out of the last

(footnote continued on next page)

929

The NASD Plan contemplated the establishment of an over-the-counter
("OTC") market for the trading of standardized options. The Plan would
have permitted the trading of options with respect to underlying securities
traded exclusively in the OTC markets as well as underlying securities
listed on the stock exchanges. In addition, the Plan envisioned trading
options that are already listed and traded on the options exchanges and thus
an expansion of multiple trading. The NASD also proposed to allow
registered NASDAQ marketmakers to make simultaneous markets in NASDAQ
options and their underlying securities. Accordingly, the NASD Plan
presented three fundamental issues that must be considered when evaluating
proposals to permit OTC trading of standardized options: (i) whether
standardized options should be traded with respect to underlying securities
traded exclusively in the OTC markets, (ii) whether the multiple trading
of standardized options should be allowed to expand to the OTC markets,

(footnote continued)

four fiscal years. In addition, the Plan required that (i)
an issuer of underlying securities have at least 8,000,000
shares owned by persons other than those required to report
their stock holdings under Section 16(a) of the Act [15 U.S.C.
78p(a)], (ii) there be at least 10,000 beneficial owners
of the underlying security, (iii) aggregate trading volume
reported to the NASDAQ system and/or on the exchange on which
the underlying security is listed be at least 2,000,000 shares
per year in each of the two previous calendar years, and
(iv) a representative bid of at least $10 per share be
recorded for the underlying security on NASDAQ or an exchange
on each business day of the six calendar months preceding
the date of selection. See NASD Plan, Proposed Article XVT,
Section 3, Schedule D, Part IV, Section 6.

930

and (iii) the extent to which the trading of options and their underlying
securities should be integrated in an OTC environment. This section will
discuss these issues.

A. Standardized Options and Underlying Securities Traded Exclusively
in the Over-the-Counter Markets

The NASDAQ system is a network of computers and communications devices
designed to accept and distribute quotations for securities traded in
the OTC markets. 299/ Quotations are publicly disseminated by means of
display terminals that NASDAQ, Inc. , a wholly owned subsidiary of the
NASD, which operates NASDAQ, provides to system subscribers. 300/ Three
levels of quotation services may be provided. Level 1, which is used
primarily by registered representatives of broker-dealer firms, does not

299/ Although only a small portion of OTC equity securities are included
in the NASDAQ system, trading in those securities accounts for
an overwhelming percentage of both the dollar value and share
volume of equity trading in the OTC market. For its securities
to be eligible for inclusion in the NASDAQ system, an issuer
must have at least $1,000,000 in total assets and $500,000 in
net assets, a minimum of 100,000 shares outstanding, and a minimum
of 300 shareholders of record. NASD Bylaws, Article XVI, Section
3, Schedule D, Part II, B and C. In addition, the issuer must
pay an issuer quotation fee if it wishes to have its securities
quoted in the system. Id. , at Part V.

300/ Anyone wishing to make a market in a NASDAQ-quoted security and to
have his quotations for that security displayed on NASDAQ terminals
is required to be an NASD member and to register with the NASD as a
marketmaker. Registered marketmakers are subject to various
obligations and restrictions set forth in the NASD's Bylaws. See
NASD Bylaws, Article XVI, Section 3, Schedule D at Part IC3.

931

display the actual quotations of specified marketmakers. It displays,
instead, for each security quoted in the NASDAQ system, a single "repre-
sentative bid and ask" quotation ("RBA" ) consisting of the median bid
price and the approximate median offer price of all registered market-
makers 301/ who have entered quotations for that security into the NASDAQ
system. 302/ Level 2, which is generally used by traders and large insti-
tutional investors, displays, in a montage, with respect to each security
quoted in the NASDAQ system, the bid and offer prices of each registered
marketmaker who enters quotations for that security into the NASDAQ system.
Level 3, which is available only to registered marketmakers, 303/ displays
the same information as Level 2 and also permits NASDAQ marketmakers to
enter and update bid and offer quotations.

301/ The nature of the RBA is described in the design specifications of the
NASDAQ system as follows:

Representative Bid and Ask — The representative bid for a
NASDAQ security is the median of all bids entered into the NASDAQ
system by registered NASDAQ market makers. The representative ask
for a NASDAQ security is the figure determined by adding the median
of all spreads to the representative bid (a spread is the difference
between the bid and ask of registered NASDAQ market makers).

When there is an even number of quotes for a security, the
median values are determined by rounding down both the bid and
the spread.

302/ NASD By-Laws, Article XVT, Section 3, Schedule D, at Part IC2.

303/ Id.

932

NASDAQ, however, does no more than provide quotation information for
stocks included in the NASDAQ system. It does not, for example, publicly
disseminate information concerning transactions in NASDAQ stocks as these
transactions take place. As a result, real-time last sale reporting with
regard to stocks traded exclusively in the OTC markets is not available. 304/

NASDAQ options marketmakers would be required to submit continuous
two-sided quotations for the NASDAQ options for which they would assume
marketmaking responsibilities. Their quotations would be required to
be firm for at least one contract and "reasonably related to the then
prevailing market." 305/ The Plan, however, would not impose an obligation
upon NASDAQ options marketmakers, similar to that imposed upon all exchange
marketmakers, to deal when there exists a lack of price continuity, a
temporary disparity between the supply of and demand for an option contract,
or a temporary distortion of the price relationships between option contracts
of the same class. 306/ In addition, NASDAQ marketmakers would be permitted,

304/ Stocks that are traded on an exchange and are included in the consoli-
dated transaction reporting system may be included in NASDAQ and
traded in the OTC market. Transaction information with respect to
OTC transactions in these securities is included in the consolidated
system although not in NASDAQ. See 17 C.F.R. 240.17a-15(a) ; NASD
By-Laws Article XVIII, Section 3, Schedule G.

305/ See NASD Plan, supra, n.90, Proposed Article XVI, Section 3, Schedule D,
Part IV, Section 3(k).

306/ See, e.g., CBOE Rule 8.7(b); AMEX Rules 170 and 958; PHLX Rules 1014(f)
and 1020(b); PSE Rule VI, Section 79(b); MSE Article XLVII, Rule 6(b).
See discussion at 114-115, supra.

933

with the approval of the NASD, to suspend quotations upon a showing that

their ability to enter quotations has been seriously impaired, 307/ and

would be able to terminate their registration as a NASDAQ marketmaker in

a particular option series voluntarily merely by withdrawing their quotations. 308/

Reregistration as a marketmaker would be permitted at any time upon the filing

of an application for reregistration and NASD approval. 309/

1. The Absence of Real-Time Last Sale Reporting For
underlying Securities Traded Exclusively in the
Over-the-Counter Markets

The absence of real-time last sale reporting of transactions in underlying

securities traded exclusively in the over-the-counter market may present

questions of fairness if options trading with respect to these securities is

permitted. Because options prices depend upon and react to changes in the price

of the underlying security, the lack of real-time transaction reporting for

underlying securities may make it difficult to determine the value of an

option at any given point in time or to adjust options or stock positions in

accordance with price changes in the underlying security. In this regard,

CBOE has stated:

307/ Such a suspension of quotations would not necessitate the termination
of the marketmaker 's registration as a NASDAQ marketmaker for the
security involved.

308/ NASD Plan, supra, n.90, Proposed Article XVI, Section 3, Schedule D,
Part TV, Section 3(k).

309/ The NASD Plan suggests that the same standards would be applied in
evaluating applications for reregistration as would be utilized in
connection with initial applications. NASD Plan, supra, n.90,
Proposed Article XVI, Section 3, Schedule D, Part IV, Section 3(j)(4).

934

Because of the derivative nature of options, * * *
it is fair to say that the single most essential item
of information for informed investing or trading is
real-time information as to underlying stock prices.
In a professional market, with large and relatively
infrequent trades, there may be other means for
providing adequate dissemination of price trends in
underlying or related securities. But in an active,
public options market, an investor (or his registered
representative) lacking real-time information on
underlying stock prices would necessarily be operating
partly in the dark. The lack of this fundamental
information on a continuous, real-time basis could
therefore result in a public options market that was
neither fair nor orderly. 310/

An example may help to illustrate these points. Assume that an

institutional investor approached a NASDAQ marketmaker during the first

week of January to buy 10,000 shares of XYZ. Also assume that the high

sale price for XYZ during the previous day was $50 per share and the best

bid currently displayed on NASDAQ Level 2 service is $49 7/8 and the best

offer is $50 1/8. Also assume that January 40, 45, 50 and 55 put and call

options, in addition to various April and July series, have been issued

on XYZ. Were the NASDAQ marketmaker to sell 6,000 shares to the institution at

a price of $51, knowledge of this transaction might have a significant effect

upon the valuation of the January and other options by other marketmakers

and market participants. Marketmakers, for instance, might increase their

bid and offer quotations in the January 40 and 45 calls to reflect an increase,

310/ OBOE Letter, supra, n.87, at 51 (footnote omitted)

935

perhaps in the amount of $1, in the intrinsic value of those options, or
might decrease their bids and offers in the January 55 puts by a similar
amount. In addition, other marketmakers and market participants might seek
to adjust positions in accordance with the price increase. A market
participant with a short position in the January 50 calls, for example,
might execute closing purchase transactions or might purchase stock to
hedge the short position. A marketmaker, on the other hand, with a long
position in the January 50 calls might sell January 55 calls or April 50 calls
to spread the risk of the long position. Without real-time last sale
reporting of the transaction in XYZ, however, persons other than the
institution and the marketmaker completing the trade would not know the
size or price of the transaction or even that the transaction had occurred.
As a result, they may not have an opportunity to adjust their quotations and
positions to reflect the transaction.

Further , without real-time last sale reporting of underlying security
transactions, investors may be compelled to rely exclusively upon underlying
stock quotation information provided by the NASDAQ system in making pricing
decisions concerning NASDAQ options. 311/ In this connection, it should
be noted that NASDAQ marketmakers may not adjust quotations when transactions
occur at prices away from the quoted prices but might adjust such quotes

311/ It must be noted that NASDAQ quotations are required to be
firm for only one round lot and do not indicate any greater
number of shares for which the bid or offer will be firm.

936

if no transaction or significant market event were to take place. For
instance, in the above example, the NASDAQ marketmaker that sold the
6,000 shares of XYZ may, at the time of the sale, have been bidding $49 7/8
and offering $50 1/4 for XYZ. If he were also making markets in the XYZ
NASDAQ options, he may have been bidding $10 and offering $10 3/8 for the
January 40 calls. After the sale, these quotations might not change
and thus would not indicate that a transaction had occurred which might
suggest that the January 40 calls should have an intrinsic value of $11. 312/
As a result, market participants, trading solely on the basis of quotations,
may not have an opportunity to make an independent judgment concerning
the prices at which XYZ and the XYZ options should trade in light of the
6,000 share transaction or to assess the risk associated with their stock
and options positions in view of that transaction. 313/

NASD, however, has responded to the suggestion that it implement
real-time last sale reporting on at least three occasions in the context

312/ Similarly, real-time last sale reporting of option transactions

may not provide market participants with sufficient information to
allow proper option pricing. If, for example, the dual marketmaker
were to purchase the January 40 calls at between $10 and $10 3/8, or
at slightly higher prices, other market participants who did not receive
real-time last sale reports of these purchases may have no reason
to believe that such transactions may not reflect the value of
those options since the purchases would be at prices reasonably
related to the marketmaker 's quotations.

313/ See Letter to George A. Fitzsimmons, Secretary, Securities and Exchange
Commission, from James F. Dalton, Secretary, CBOE, dated March 31,
1977, at pp. 5-6.

937

of its proposed options plan. 314/ NASD has stated that "trade reporting
of transactions in over-the-counter securities underlying options
in the detail it believes necessary would be unnecessarily burdensome and
extremely time consuming to members if imolemented on a real-time basis." 315/
In addition, NASD has pointed out that real-time last sale reporting
of underlying security transactions might "create public confusion" since
the 'Consolidated Tape presently prints transactions at prices which are
exclusive of any commissions or differentials charged" whereas last sale
reports of transactions by over-the-counter dealers might, if not reported
via the consolidated tape and in accordance with its rules, "reflect the
actual or net price paid or received." As a result, it may be difficult
for market participants to interpret last sale information. 316/ Further,

314/ Letters to George A. Fitzsimmons, Secretary, Securities and Exchange
Commission, from Gordon S. Macklin, President, NASD, dated March 18,
1977, and October 19, 1977; Letter to Sheldon Rappaport and Martin
Moskowitz, Division of Market Regulation, Securities and Exchange
Commission, from Frank J. Wilson, General Counsel, NASD, dated
May 31, 1977.

315/ See Letter to George A. Fitzsimmons from Gordon S. Macklin dated
March 18, 1977, supra, n.314, at 2.

316/ Article XVTII of the NASD By-Laws and Schedule G thereunder initially
required ;,net" price reporting for over-the-counter transactions in
listed securities for the several months immediately after the imple-
mentation of Network A of the Consolidated Transaction Reporting
System. Subsequently, the Commission approved an NASD rule change
which, among other things provided that over-the-counter principal
transactions in listed securities be reported in the Consolidated
System at "gross" prices. In other words, the price reported to the
Consolidated System, like all other prices reported to that system,
does not include any commission, commission equivalent, or differential
imposed in connection with the transaction. See Securities Exchange
Act Release No. 12432 (May 12, 1976).

938

the NASD has suggested that requiring real-time last sale reporting for
transactions in securities traded exclusively in the over-the-counter
markets may result in reduced marketmaking capacity in those markets. 317/

2. Representative Bid and Ask Quotations For Securities Traded
in the Over-the-Counter Markets

With respect to representative bid and ask quotations for securities

traded exclusively in the OTC markets, the Commission recently observed:

Information supplied by the NASD and representatives
of the securities industry indicates that broker-dealer
firms tend to supply their registered representatives who
deal with the public with Level 1 service exclusively.
Level 2 and 3 services are generally maintained by
broker-dealer firms in their trading rooms for use
in connection with trading and marketmaking activities.
Because registered representatives of the larger
wirehouses cannot for practical reasons communicate
orally with the trading rooms of their firms on a
continuous basis to obtain real-time quotations,
retail customers of these firms generally do not have
access to the information provided by Level 2 and
3 services. Moreover, many smaller, nonclearing
firms do not subscribe to Level 2 or Level 3 service
and thus are only able to supply their customers with
information available on Level 1. Therefore, since
most retail customers generally cannot obtain real-
time quotations for NASDAQ securities other than through
the registered representatives with whom they deal,

317/ See, e.g., Testimony of Gordon S. Macklin, President, NASD, August 16,
1977, in response to Securities Exchange Act Release No. 13662, supra,
n.124, File No. 4-180 at Transcript, pp. 978-981 and 1044-1045.

939

the practical effect of displaying the RBA on Level 1
is that the vast majority of retail customers are
informed only of the RBA. 318/

The Commission also stated its belief that "the behavior of some broker-
dealers in executing their customers' orders may be affected by the
knowledge that their customers do not have access to the best bid
and offer then available." 319/ Moreover, the Commission expressed
concern that "it is only feasible for a customer to police his broker's
efforts to obtain best execution if he receives information as to the
best bid or offer available at the time he places an order to buy or sell
a NASDAQ-quoted security." 320/ Accordingly, the Commission proposed

318/ Securities Exchange Act Release No. 15251 (October 20, 1978),

15 SEC Docket 1370, 1381-2 (November 17, 1978) (footnotes omitted).

319/ Id., at 1382. To demonstrate this point, the Commission stated:

For example, some commentators have noted that certain
broker-dealers execute customers' orders at the RBA displayed
on Level 1 without first attempting to obtain more favorable
executions. Futhermore, at the Commission's hearings in
August 1977 considering the amendment of off-board trading
rules * * *, one commentator stated that an integrated
firm may deal with its own retail customers at the RBA
quoted on Level 1 despite the fact that the firm's quota-
tions, as a marketmaker in NASDAQ, were at a better price.

Id. (footnote omitted).

320/ Id. In this connection, the Commission stated:

A retail customer who is informed only of the RBA at
that time cannot properly evaluate the quality of
execution and price of services rendered by the

(footnote coninued on next page)

940

Rule llAcl-2 321/ which would require that every interrogation device
providing quotation information with respect to OTC equity securities
display, at a minimum, the highest bid and lowest offer for each such
security. 322/ The proposed amendments would also prohibit the display
of "any representative bid or offer for a security — i.e., any price
for a security which is the mean, median, mode, or weighted average of
two or more bids or offers or is the result of some other mathematical
calculation based on the bid or offer of one or more marketmakers . " 323/

The NASD Plan proposed to display representative bid and ask
quotations for NASDAQ options. As a result, the concerns that led to

(footnote continued)

broker-dealer handling his order. This is parti-
cularly true when a broker-dealer had executed an
order as principal and has confirmed the trans-
action "net" to the customer because there is
currently no required disclosure of the amount
of retail markup or markdown included within the
"net" price. In addition, retail customers who
are not knowledgeable about the operation of the
over-the-counter markets may believe that the
RBA quotation they generally receive for a NASDAQ-
quoted security actually is the best bid or offer
available for that security.

Id.

321/ See Securities Exchange Act Release No. 15251, supra, n.318.

322/ Id.

323/ Id., at 1383 (footnote omitted).

041

the pending proposal to prohibit such quotations for NASDAQ stocks
would be equally present with regard to NASDAQ options if the NASD Plan
were implemented as proposed. Moreover, RBAs for underlying securities
traded exclusively in the OTC market may make it difficult for members of
the public without access to Level 2 or Level 3 service to make informed
investment decisions with respect to NASDAQ options. Without quotation
information revealing the best prices bid and offered for an underlying
stock, the range of bids and offers available, and the number of
shares for which each bid and offer is firm, market participants
receiving only Level 1 service may not be able, due to the derivative
nature of option pricing, to determine effectively the value of NASDAQ
options that they may wish to buy or sell or the prices at which they
might be willing to trade such options. The absence of real-time last
sale reporting on underlying securities traded exclusively through NASDAQ
would compound a Level 1 user's difficulty. 324/ The following example
that AMEX has provided may help to show these points:

324/ AMEX has described the concerns relating to trading options on
underlying securities traded solely over-the-counter and as
to which only representative bid and ask quotations are avail-
able as follows:

The options market is a derivative of the market
for the underlying stock, and options investment
decisions are to a large extent based on available
information concerning the value of the underlying
stock, that is, the price at which it can currently
be bought or sold. Investors normally determine the
value of a stock by reference to a number of factors.

(footnote continued on next page)

40-940 O - 79 - 62

942

[I]f the representative quote in an over-the-counter
stock were 40 bid and 41 asked, the options investor
would have no idea whether the stock is realistically
to be valued at 40, 41 or somewhere in between. Further-
more, there will be no up-to-date last sale information
to help him in making the valuation. This one point
difference will affect the price of any option, and
particularly one trading at or near parity where option
or ices normally fluctuate point for point with movements
in the or ice of the underlying stock. With a quote of

(footnote continued)

The most reliable indication is the current
quotations, provided such quotations are firm and
they reoresent sufficient depth to assure there will
be no severe fluctuations in price on minimal volume.
Last sale data is also a valuable source of information
in determining value, provided it is current, accurate
and complete. It indicates the latest price at which
a transaction actually took place, the volume, the
degree of price volatility, and the kind of price
continuity characteristics of the market in the
security.

Investors attempting to ascertain an aporopriate value
for stocks traded in the over-the-counter market, of
course, do not have the benefit of such last sale
information on a real-time basis. In addition, they
are handicapped by the fact that the "mean" bid and asked
quotations displayed in the NASDAQ system do not
necessarily mean there is a market maker willing to buy
or sell at those prices, but only that the quotations
are representative of the various prices at which the
market makers registered in the stock may be willing
to deal. As a result, it will be almost impossible
for an investor to make an informed decision with
respect to an option on a stock traded solely over-the-
counter , and uninformed decisions may be costly.

(footnote continued on next page)

943

40 bid, 41 asked on an underlying stock approximately
two weeks before the expiration date, a 35 call option
trading at parity would be worth 5 if the stock could be
realistically valued at 40, 5-1/2 if it were worth
40-1/2, and 6 if the stock could be realistically
valued at 41. With such tenuous knowledge as to
the stock's true value an investor might pay a price
of 6 for an option worth only 5. It should be noted
that this one point differential represents 20% of the
option's value. When a low-price option is near
expiration a moderate spread in the quote on the
underlying stock could represent a differential
in the options price of perhaps 50% or more. 325/

( footnote cont inued )

Even worse than the fact that the public investor
will not have sufficient information on which to base
an accurate appraisal of the worth of the option, is
that the market professional will have greater access
to such information, thus giving him a significant trading
advantage over the public investor. The NASD plan
contemplates that the same OTC market makers will make
markets in both the underlying stocks and the related
options. Such market makers will, therefore, have
intimate knowledge of the price and volume at which the
underlying stock has been trading.

The lack of real-time volume information in the
underlying stocks traded over-the-counter may be as
significant as the lack of real-time price information.
In view of the fact that the real "size" of a dealer's
quote also may not be ascertainable, investors will be
unable to judge the depth in either market. Without
adequate means to determine the depth and liquidity of
the market for an underlying stock, the true risk of a
position in the related option cannot be properly
evaluated.

AMEX Letter, supra, n.90, at 77-80.

325/ AMEX Letter, supra, n.90, at 78-79.

944

It must also be recognized that market professionals with access to Level 2
and 3 service would possess information concerninq the range and number
of quotations for underlyinq NASDAQ stocks and thus would have significant
trading advantages over other market participants. 326/

The Commission has recognized that the elimination of representative
bid and ask quota ions may impose burdens on CTC marketmakers who must
respond to customer inquiries concerning transactions that were executed
at other than the best bid or offer available. 327/ In addition, the

326/ See n.324, supra.

327/ In Securities Exchange Act Release No. 15251, supra, n.318,
the Commission stated:

The Commission is aware that a broker-dealer
who has executed a customer's order at a price
other than the best bid or offer may have had
justifiable reasons for doing so (e.g., the best
bid or offer may not have been firm for the size
of the customer's order; the cost of execution
and clearing with the market-maker responsible
for the best bid or offer might off-set the price
advantages to the customer ; or the broker might
have reason to believe it imprudent to deal with
the dealer responsible for the best quotation).
We are also aware that, in such circumstances,
a customer's knowledge of the best bid or offer
might necessitate an explanation by the
executing broker-dealer of the facts and cir-
cumstances underlying his decision to execute
the order at a price inferior to the best bid
or offer. However, it would not appear that
providing such an explanation would constitute
an unduly heavy burden. Moreover, the Commission
believes that the benefits to be achieved by
dissemination of the best bid or offer would
justify the imposition of such a burden.

Id., at 1382-3 (footnotes omitted).

945

Commission has solicited public comments with regard to the effects

that eliminating RBA's might have on the OTC markets. In this connection,

the Commission noted:

It has been asserted on various occasions that,
possibly because of inherent differences between
dealer and auction markets, some innovations
which improve the quality and efficiency of the
markets for securities which are suitable for
auction-type trading would have a deleterious
effect on over-the-counter markets for other
types of securities. For example, during the
off -board hearings, the NASD suggested that last
sale reporting of transactions in OTC securities
might discourage market-making in those securities,
thus decreasing liquidity in the over-the-counter
market. It also implied that the display of best
bid and ask prices on Level 1 of NASDAQ would
have similar effects. 328/

B. Trading Exchange Listed Options in the Over-the-Counter Markets

To permit the trading of exchange listed options in the over-the-counter
markets would involve an expansion of multiple trading. Accordingly, the
factors discussed previously in connection with multiple trading should
also be considered when evaluating proposals to allow options listed on
the options exchanges to be traded in the OTC markets. 329/ Some additional
factors, however, should also be considered due to the differences between

328/ Id. at 1383 (footnotes omitted).
329/ See discussion at 65-92, supra.

946

OTC dealer markets and exchange markets. These additional factors will
be presented in this section. 330/

1. Fragmentation and Internalization

Multiple trading of standardized options currently results in a
dispersion of options orders among various exchange markets. 331/ Permitting
an OTC market to develop for option classes already traded on one or more
exchanges may provide numerous other markets to which these orders could
be sent, each dealer making a market in the multiply traded class through
NASDAQ representing an additional market center seeking to attract orders
for that class. While such a situation would undoubtedly create the potential
for further dispersion of orders for multiply traded options classes among
market centers, fragmentation issues of another type must also be considered.

Dealers making markets through NASDAQ from their offices 332/ may
be able to trade multiply traded classes as principal with their own

330/ This section assumes that the rules of the options exchanges which
preclude members of these exchanges from engaging in listed options
transactions anywhere other than on an exchange floor would not
be in effect. This assumption has been made because brokerage firms
who are members of these exchanges would not be able to participate
in an OTC options market for listed options if such rules were
operative. Without the participation of these firms, the development
of such a market may be unlikely. But see n.337, infra, and discussion
at 271, infra.

331/ See discussion at 49-52, 61-65, supra.

332/ These dealers are sometimes referred to in this chapter as "upstairs
dealers."

947

retail customers. If an upstairs dealer elects to trade a multiply
traded option with his customer, the customer's order may not be sent
to an exchange floor for execution. As a consequence, the customer's
order may not be exposed to buying and selling interest that may have
been present in the marketplace. This result, as CBOE has suggested,
may "be contrary to the statutory goal of assuring an opportunity
for orders to meet in an auction market without the participation
of a dealer," 333/ and may "lead to a market divided into as many
separate fiefdoms as there are major brokerage firms, each with its own
captive order f low. " 334/ Ultimately, a redirection of orders away
from exchange floors may "impair the depth and liquidity of [the]
markets [for multiply traded classes], and significantly impair the
ability of such markets to provide public limit order protection." 335/
In addition, the ability of upstairs dealers to trade as principal with
their retail customers without exposing their customers' orders to the
auction market on an exchange may "raise the regulatory issues of
overreaching and other conflicts of interest that were addressed in

333/ CBOE Letter, supra, n.87, at 48. See also Section llA(a)(l) (C) (v)
of the Exchange Act [15 U.S.C. 78k-l(a) (1) (C) (v)] . It should be
noted that this statutory goal is qualified in two respects.
See n.27 and accompanying text.

334/ Id.

335/ AMEX Letter, supra, n.90, at 84.

948

connection with the Commission's consideration of off-board trading
rules for stocks." 336/

Thus, many of the concerns that the Commission expressed in connection
with its recent review of off-board trading restrictions may be as
applicable to the options markets as they are to the stock markets. 337/
These concerns are factors that should be considered as proposals
contemplating CTC trading of options listed and traded on the options
exchange are evaluated.

2. Market Information and Competitive Advantages of
Cver-the-Counter Marketmakers

Over-the-counter marketmakers may have market information and
competitive advantages that other market participants, including options

336/ CBOE Letter, supra , n.87, at 49. See also Securities Exchange Act
Release No. 13662, supra, n.124; No. 11628, (September 2, 1975),
7 SEC Docket 762 (September 16, 1978); and No. 11942, supra,
n.210; and Report of the Securities and Exchange Commission on
Rules of National Securities Exchanges Which Limit or Condition the
Ability of Members to Effect Transactions on Such Exchanges,
September 2, 1975.

337/ It should be noted, however, that the Commission has not sought
to resolve issues that may be presented by the off-board trading
restrictions currently in effect with respect to standardized
options that are traded on a national securities exchange. See,
e.g., CBOE Rule 6.49. See also Securities Exchange Act Release
No. 13662, supra, n.124, at n. 157. The Commission, in the course
of its continuing review of these restrictions, may wish to consider
issues similar to those presented in connection with the proceedings
concerning the removal of off-board trading restrictions for
listed equity securities. See January Release, supra , n.176,
at 41. See also File No. 4-180. See discussion at 271-272, infra.

949

marketmakers on options exchange floors, would not have. As CBOE has
stated :

First, such a firm would have access to a regular
flow of orders through its retail deoartment;
it could either internalize these orders or send
them to an exchange market for execution,
depending on whether the firm believed it could
realize more profit by acting as principal or
agent. On the other hand, exchange market-makers
have no comparable access to an order flow or
comparable choice. Being deprived of the order
flow that would be captured upstairs, their
ability to function as market-makers would be
impaired and trading profits would be more
difficult for them to realize. Second,
because the upstairs retail firm would have
an assured source of orders, there would be
no need for it to publish competitive
quotations to attract orders. Exchange
market-makers, on the other hand, must
publish competitive quotations to stay in
business, and these would be subject to being
"picked off" by the upstairs market-maker.
Third, * * * any upstairs market-maker having
a significant percentage of aggregate order
flow which it was permitted to internalize
would have special access to significant
nonpublic market information. 338/

Moreover , AMEX has observed :

Specialists and other market makers on options
exchanges would be at severe disadvantage vis-a-vis
the market makers registered as such with the NASD.
The NASD market makers will have no affirmative
obligations to engage in transactions reasonably
calculated to contribute to the maintenance of a
fair and orderly market. This fact, plus the ease
with which they will be able to suspend quotations

338/ CBOE Letter, supra, n.87, at 49 (footnote omitted)

950

or terminate registration as a market maker, will mean
that NASD market makers need not commit to the market
the amount of capital that is required of exchange
market makers. With the leverage of market-maker
"margin", they may seek to take whatever positions
will bring them the maximum profit, because they
will be confident they can liquidate their positions
in the exchange market, thereby minimizing their
risks. This will place a significantly increased
burden on exchange market makers to maintain fair
and orderly markets. 339/

It should also be kept in mind that if dual marketmaking is

permitted in the over-the-counter markets, OTC options marketmakers may

have access to information concerning underlying stocks that they are

trading that would not be available to other market participants.

Dual OTC marketmakers, for example, may be able to trade options on

the basis of customer stock orders and transactions as well as indications

of buying and selling interest for an underlying stock in which they are

making markets. Such informational and competitive advantages may take on

added significance and impact the competitive balance among options

marketmakers profoundly if comparable integration is not permitted on

exchange floors. In this regard, CBOE has contended:

Obviously, if the NASD proposal for dual market-
making were approved at the same time that dual
market-making were not allowed in exchange markets,
the result would be to provide OTC market-makers
with a significant competitive advantage. Even
more obviously, if at the same time an upstairs

339/ AMEX Letter, supra, n.90, at 85,

951

market-maker, unlike an exchange market-maker ,
were able to internalize its retail order flow
by trading as principal with its customers * *
the combination of these two advantages would
severely limit the capability of any exchange
market-maker to compete. 340/

3. O/er-the-Counter Markets and a National Market
System Which Would Include Standardized Options

An over-the-counter market for options traded on exchanges does

not exist at present. Should such a market evolve before national market

system facilities for options trading are in place, the task of

establishing a national market system which would include standardized

options may become more difficult. The office of each upstairs options

dealer, for example, would have to be connected to any system linking

market centers in a national market system that included options.

In addition, the differing principles that govern dealer and auction

market options trading may have to be reconciled as may gross and

net pricing differences that may develop. 341/ Further, the difficulties

associated with maintaining accurately sequenced real-time transaction

and quotation reporting and system-wide limit order protection may

be exacerbated. 342/

340/ CBOE Letter, supra, n.87, at 50.

341/ See discussion at 159, 167-173, supra.

342/ See CBOE Letter, supra, n.87, at 47. With respect to the problems
that may be encountered when attempting to assure public limit order
protection in an OTC options market, CBOE has stated:

(footnote continued on next page)

952

The Integration of Trading of Options and Their Underlying
Securities in the Over-the-Counter Markets

The NASD Plan contemolated that options and their underlying securities

would be traded by the same persons or firms. The Plan proposed a complete

integration of marketmaking functions and the trading of options and their

underlying securities at the same physical location. With respect to the

dual marketmaking aspects of its program, NASD stated:

Firms most likely to become marketmakers in
NASDAQ options are the same firms that currently
make markets in the underlying securities on
NASDAQ. It is unlikely that firms other than
NASDAQ marketmakers will choose to be NASDAQ
options marketmakers only or that a marketmaker
in a given NASDAQ underlying security will choose
to make a NASDAQ options market involving an
underlying security with which it is unfamiliar,
i.e., an issue in which it is not a NASDAQ
marketmaker. Also, it would not be in the public
interest for a NASDAQ market-maker to drop his
marketmaking activity in a NASDAQ issue in favor
of making a market in a NASDAQ option. In
reality, it would not do so.

(footnote continued)

It would be especially difficult to achieve system-wide
limit order Drotection in such a market, not only because
of the inherent difficulties of linking the many separate
upstairs locations where limit orders would be held, but
also because an upstairs firm's self-interest would encourage
it to hold customer orders away from any central limit order
file that might be created.

Id., at 48.

953

In sum, if dual marketmaking is not permitted, it
is unlikely that the NASDAQ options programs will
be implemented. 343/

In its analysis of the issues relating to dual marketmaking, NASD
stated that dual marketmaking through NASDAQ would "entail substantial
benefits to investors and the marketplace" and noted its belief that
'dual marketmaking in the closely regulated, highly visible NASDAQ
market will not create significant new opportunities foe manipulative
abuses by marketmakers." 344/ In this connection, NASD was of the view
that "the quality of the underlying securities [on which NASDAQ options
would be issued 1 , the number of competing marketmakers [entering quotations
in the NASDAQ system], the volume of trading activity [in the underlying
securities] , and a requirement that there be a minimum number of market-
makers in both the underlying security and the [NASDAQ] option before
anyone would be permitted to make a dual market" would be sufficient
safeguards to minimize the ability of a dual marketmaker to manipulate
an underlying NASDAQ security or its options. 345/ Additionally, a
'comprehensive package of rules" to govern the operation of the NASDAQ

343/ National Association of Securities Dealers, "An Analysis of
the Issues Relating to Dual Marketmaking on NASDAQ, May 14,
1976:' ("Analysis"), at 29. This analysis was submitted in
response to Securities Exchange Act Release No. 10312,
supra, n.219.

344/ Id., at 2.

345/ Id., at 11-12.

954

trading system and "extensive examination and surveillance programs"

were expected to have a "significant deterrent and preventative effect." 346/

When evaluating OTC market integration proposals such as NASD's,
the same basic factors should be considered and balanced as when evaluating
integration proposals made by exchanges. Because of the characteristics of
the OTC dealer markets, however, analysis of these factors must be modified
in two significant respects. First, as NASD has pointed out, 347/ an OTC
options market may not be feasible without dual marketmaking. Concurrent
and side-by-side trading in the over-the-counter markets, for example, may
not be viable methods of trading stocks and related options in the over-the-
counter markets due to the difficulty, if not impossibility, of separating
trading functions where trading occurs in the offices of securities dealers.
If this NASD perception is correct, 348/ consideration of improvements in

346/ Id., at 12.

347/ See n.343, supra, and accompanying text.

348/ Although NASD has consistently maintained that an OTC options markets
will not be feasible without dual marketmaking, it is not readily
apparent why it is "unlikely that firms other than NASDAQ market-
makers [would] choose to be NASDAQ options marketmakers only or that
a marketmaker in a given NASDAQ underlying security [would] choose
to make a NASDAQ options market involving an underlying security

with which it is unfamiliar * * * ." Analysis, supra , n. , at

29. Indeed, options marketmakers on exchange floors have made options
markets without making stock markets since the inception of standardized
options trading, and it appears that they have become "familiar"
with the securities underlying the options that they trade without
inordinate difficulty. In addition, if OTC options trading presents
a potential for earning profits, economic theory suggests that market-
making capital and talent should flow to such trading.

955

market quality may be limited to those obtainable as a result of dual
marketmaking. Similarly, it may not be necessary to consider the
extent of integration as a variable during the balancing process
since only one form of integration may be feasible.

Second, consideration of the character of the market proposing
the integration has different overtones when integration is proposed
for the OTC markets. 3ecause the OTC markets are composed of a network
of competing dealers, each of whom makes independent markets from his
office, and since each competing marketmaker maintains exclusive access
to any limit orders that his customers may leave with him, no OTC market-
maker is likely to have market information and competitive advantages
or opportunities to engage in manipulative or other improper practices
of the nature and dimension of those that integration would create
for a unitary stock specialist on a primary stock exchange with a
centralized stock limit order book to which he alone has access. More-
over, given the number of marketmakers that may be registered to make
markets in an underlying security 349/ and that each of these marketmakers
is essentially a market center, primary and secondary market determinations
may be at best tenuous. As quotations change and customers provide

349/ The average number of registered marketmakers for a NASDAQ security
in 1977 was 7.6. 1977 NASDAQ/GTC Fact Book, at 9. The NASD Plan
provided that at least 10 registered NASDAQ marketmakers would be
required to be displaying quotations in a security underlying NASDAQ
options prior to the commencement of dual marketmaking. NASD Plan,
supra, n.90, Proposed Article XVI, Section 3, Schedule D, Part IV,
Section 3(a).

956

orders, the NASDAQ marketmakers or group of marketmakers maintaining
the best market, in terms of both prices quoted and number of shares
or contracts to be bought or sold at quoted prices, may be "primary"
in the sense of attracting more order flow than others at that time.
These factors, of course, are highly dynamic, and, as a result,
primary market determinations may not take on the same significance
as in exchange markets. On the other hand, the opportunity to trade
against the orders of retail customers in an OTC market may present
market information and competitive advantages and regulatory concerns
that do not have counterparts in exchange markets. 350/

Within this context, the regulatory concerns that may accompany
dual marketmaking in the OTC markets will be discussed.

1. Market Information, Competitive Advantage and Improper
Trading Practices

NASDAQ dual marketmakers may be exposed to substantial inquiry and
order flow in NASDAQ options and their underlying securities. The absence
of real-time last sale reporting with regard to stock transactions, when
coupled with the ability of a NASDAQ marketmaker to complete stock trans-
actions at prices other than those quoted in NASDAQ without adjusting
quotations or otherwise indicating that a transaction has occurred, may
enhance the ability of a NASDAQ dual marketmaker to utilize inquiry and

350/ See discussion at 170-173, supra.

957

transaction information with regard to the underlying security to earn
profits on option positions. 351/

The example discussed above in connection with real-time last sale
reporting may illustrate some of these points. In that situation,

351/ With respect to these points, CBOE has stated:

The absence of publicly reported current trans-
action information would also give rise to many
situations where particular dealers would have
access to market information not generally available.
For example, a dealer in an underlying stock traded
on NASDAQ will commonly know of transactions that
have actually taken place in the underlying stock
and are not publicly reported. This information
may be extremely important in evaluating the premium
levels of options related to that stock, and its
availability to only certain market participants
suggests many possibilities for unfairness toward
public investors.

CBOE Letter, supra, n.87, at 51.

Similarly, AMEX has observed:

Dual market making in an over-the-counter options
market may in some respects present even greater
regulatory problems than it does in the context of an
exchange market, due again to the absence of real-time
last sale reporting of transactions in the underlying
stock. When a transaction takes place in the underlying
stock which could affect the value of the option, only
the market maker knows about it. The public investor
buying and selling the ootion may not be aware of the
price change in the underlying stock until he reads
about it in the financial tables the next morning.
This increases significantly the period of time within
which the market maker may act to profit from his
inside knowledge of the market.

AMEX Letter, supra, n.90, at 81.

40-940 O - 79 - 63

958

an institutional investor approached a NASDAQ marketmaker to buy 10,000
shares of XYZ. The high sale price for XYZ during the previous day
was $50 per share and the best bid displayed on NASDAQ Level II service
was $49 7/8 and the best offer was $50 1/8. The marketmaker sold 6,000
shares to the institution at a price of $51. If the marketmaker who
sold the 6,000 shares of XYZ was also making markets in the XYZ options,
he might purchase, after completing the stock sale, the January 40 or 45
calls at the prevailing bid price or by slightly improving the best
bid. He may also be able to sell the January 55 or 50 puts at the
prevailing offer price or by slightly improving the best offer. Assuming
that the market were to adjust gradually to the sale price of $51, perhaps
to indicate that XYZ was prooerly valued at $51 per share or perhaps
because other transactions, involving other marketmakers and the other
4,000 shares that the institution sought to buy, were to occur at a
price near $51 and other marketmaker quotations were adjusted accordingly,
the dual marketmaker might liquidate the long call or cover the short
put positions at a profit. 352/ Of course, the dual marketmaker 's purchases

352/ It should be recognized, however, that even when a NASDAQ dual
marketmaker is aware of an imminent stock or options transaction
it may be difficult to profit from this knowledge again due to
the absence of real-time last sale reporting and the fact that
quotations may not be adjusted to reflect transactions. If, for
example, (i) the institution that purchased XYZ from the NASDAQ
dual marketmaker was unable to find another seller and withdrew
from the market, (ii) the institution was able to buy the 4,000
remaining shares of XYZ quickly from other marketmakers at a

(footnote continued on next page)

959

of the January 40 or 45 calls, sales of the January 45 or 50 puts, and
liquidating or covering transactions may be done with customers who are
not aware of the dual marketmaker' s other trading and without exposing
these customer orders to other market participants in the OTC or exchange
markets.

Dual marketmaking in the over-the-counter market may also provide
NASDAQ marketmakers with incentives and opportunities to engage in
manipulative and other improper trading practices. These incentives
and opportunities, as on an exchange floor, may result from the inquiry
and order flow that a dual marketmaker may possess and the ability to
profit on options positions as a consequence of relatively small and rapid
price movements in the underlying security. Trading practices analogous
to those involved in the quote racing, front-running, and capping examples
discussed previously 353/ may occur in an OTC dual marketmaking environment

(footnote continued)

price not significantly higher than $51 and those marketmakers did
not adjust their quotes to reflect the transactions, or (iii)
additional sellers entered the market, the market for XYZ may not
adjust to reflect the marketmaker1 s transaction or the institutional
buying, particularly if information concerning the transaction was
not publicly disseminated and the marketmaker did not adjust his
quotations to reflect the transaction. Under these circumstances,
the marketmaker might not profit from the options position that he
had assumed although he may be able to liquidate that position
without sustaining a substantial loss since the call options may
have been properly valued when he purchased them and their prices
may not have changed.

353/ See discussion at 107-114, supra.

960

A dual marketmaker , for example, may be able to trade options on the
basis of changes he is about to make in his quotations for an underlying
security. Similarly, he may be able to engage in options transactions
as a result of customer or marketmaker orders or inquiries that he
has received with respect to an underlying security prior to the time that
NASDAQ quotations for that security change, if at all, to reflect the
orders or inquiries.

Dual marketmaking in the OTC markets may also present additional
opportunities to engage in improper trading practices. For instance,
assume that the best bid for XYZ displayed on NASDAQ Level 2 is $50 and the
best offer is $50 1/4. Also assume that A, a registered dual marketmaker
has accumulated a long position of near-term put options with an exercise
price of $55. Further, assume that the best bid for the XYZ 55 put options
is $6 and the best offer is $6 1/4. If A were a prominent dual marketmaker
and was currently bidding $50 and offering $50 3/8 for XYZ, a change in
A's bid and offer for XYZ may significantly impact the bids and offers
of other marketmakers and, at the same time, the bids and offers for the
XYZ put options. Thus, if five marketmakers were bidding $50 for XYZ
and A were to lower his bid to $49 1/2 and his offer to $49 3/4, the other
marketmakers, particularly in the absence of real-time last sale reporting,
may believe that A has effectuated a large transaction at a price substantially
below his bid price or that A is in possession of market information con-
cerning XYZ that reflected upon the company or the market for its securities

961

adversely. As a result, these marketmakers may lower their bids and offers
in a manner consistent with A's adjustments. 354/ Under these circumstances,
the best bid for the XYZ 55 put options may increase to $6 1/2. If A is
able to sell all or a portion of his long position in the XYZ 55 puts,
he may be able to earn $1/2 for each put that is sold. Again, A may be
able to sell these puts to his own customers, none of whom would have
knowledge of A's activities or an opportunity to trade with any other
market participant. In this example, A was able to earn a profit on his
option position merely by changing his quotations for the underlying
security. Of course, other market participants may purchase shares from
A at his reduced offer of $49 3/4 and A would then be at risk that the
market would return to its previous level and his profit from his options
transactions may become a substantial loss.

In this connection, the NASD has stated that the potential for
manipulating underlying NASDAQ securities will be minimal because those
securities will be "widely held and actively traded," 355/ quotations

354/ A's ability to influence other marketmaker ' s quotes may be enhanced
because of a noted phenomenon in the NASDAQ market often referred
to as "price leadership." "Price leadership" has been described
by one commentator as follows:

"* * * [W]hen a leading dealer breaks out of a
prevailing price trend, competitors tend to fall
all over one another in their scramble to match
his price. This has produced wide price swings
on relatively little volume." Bleakley, "Is
NASDAQ Really the Answer?" Institutional Investor,
July, 1971, at 25.

355/ Analysis, supra , n.343, at 12.

962

will be highly visible, 356/ substantial marketmaking competition will
exist, 357/ and position and exercise limits and NASD rules and reporting
requirements "would effectively prevent a marketmaker from achieving
a large enough position in options to utilize the options in a meaningful
fashion in any attempt at manipulation." 358/

356/ Id., at 15.

357/ Id., at 15-16. But see also discussion at 185-190, infra.

358/ Id., at 17. With regard to the rules and reports that NASD

intended to utilize "to act as safeguards for the protection of
investors and the public interest," the Association stated:

(1) * * * in order for a member to simultaneously make a market in
the underlying security and options relating thereto, there would have
to be a total of at least five registered marketmakers in the underlying
security and at least five registered marketmakers in each options
series in respect to which dual marketmaking was intended. This
provision would reduce the possibility of a given firm controlling
activity in both the option and the underlying security, and, hence,
reduce the possibility of manipulation. * * *

(2) Without prior approval of the Association, a NASDAQ options
market maker would be prohibited from acquiring a position in its
investment account, or the accounts of other members or investors,
in any class or series of NASDAQ options in excess of specified
limits. Specifically, these limitations would prohibit aggregate
long or short positions in excess of 1000 options contracts of the
same class of NASDAQ options or 500 options contracts of the same
class and expiration date. This rule is designed to prevent a
marketmaker from accumulating so large a position as to be able to
manipulate prices by having "a corner on the market" in a given
class or series of options.

(footnote continued on next page)

963

2 . Marketmaking Obligations and Commitment to the
Marketplace

The NASD Plan would not impose marketmaking obligations upon NASDAQ

dual marketmakers which would be similar to those imposed uDon exchange

(footnote continued)

(3) There would be a limitation on the number of long positions
in a given class of ootions which could be exercised within any
five-day period by a NASDAQ, options marketmaker buying for its
investment account or the account of any of its officers, partners
and employees, by any other members or by a public customer. The
purpose of this oroposal is to discourage manipulative activities

in the underlying security by limiting the number of shares which may
be acquired under options within a stated period of time and by
minimizing the effect that the exercise of substantial amounts of
options miqht have on the Drice of the underlying security.

(4) Dual marketmakers would have position and exercise limits as
to their trading accounts in addition to the above limitations in
connection with their investment accounts. Specific limits have
not yet been determined but they are under active consideration,
i.e., a position limit of 5 or 10% of the open interest; exercise
limits comparable to those imposed for investment accounts.

(5) All marketmakers, dual or otherwise, would be required to file
reports detailing the nature of the options position in excess of
established levels (which would be substantially less than the
established positions limitations) in each of its investment
accounts and the accounts of affiliates. Reports as to dual
marketmakers trading accounts would also be required. Reports
would also be required from all members with uncovered short
positions. These reporting requirements would establish an early
warning system whereby concentrated positions in options which

may be used in a potential manipulative scheme could be quickly
identified.

(6) Where excesses over established position limits occur,
prohibitions on further activity by the violative accounts
would be imposed until the excesses are liquidated.

(footnote continued on next page)

964

marketmakers. 359/ The Plan would also permit NASDAQ dual marketmakers
to suspend quotations, with the approval of NASD, upon a showing that
their ability to enter quotations is seriously impaired. Moreover,
the NASDAQ dual marketmakers would be able to voluntarily terminate

(footnote continued)

(7) Transactions in so-called "conventional options" covering
those securities in which NASDAQ options are being traded would
be required to be reported. This provision will assist in the
surveillance of all options activities in securities authorized
for NASDAQ options.

(8) The principle of full disclosure is a paramount concern
oarticularly in regard to those situations in which a member
acts in the capacity of a dual marketmaker. In that connection,
the Association is considering the desirability of a rule which
would require disclosure of this fact on confirmations sent to
customers.

(9) All NASDAQ options marketmakers, as well as all other members,
would be prohibited from entering into any option contract with an
issuer, controlling person or affiliate of the issuer if the option
covered securities of the issuer. * * *

(10) Special requirements will govern the execution of options
contracts in customers* discretionary accounts. A member would be
required to obtain the written approval of the customer specifically
authorizing options trading in the discretionary account and each
NASDAQ options transaction would be required to be approved by

a registered options principal. While these provisions are primarily
for the protection of investors, they would also make it more
difficult for members to create options trading activity through
accounts over which they have control. The use of discretionary
accounts has in the past assisted in the perpetuation of many
manipulations.

(footnotes continued on next page)

965

their registration as a NASDAQ marketmaker in a particular option series

merely by withdrawing their quotations. Reregistration would be permitted

at any time upon the filing of an application for reregistration and NASD

approval .

Expressing concern with regard to the ease of registering and withdrawing

from options marketmaking responsibilities under the NASD Plan, CBOE has

observed :

A NASDAQ options market-maker will be permitted to
register for and withdraw from that status with
relative ease. Thus, market-makers in NASDAQ options
could engage in a practice of registering for only
those series which are or have become attractive
(in the sense of trading activity) and avoiding
unattractive series or terminating their registra-
tions in series that become unattractive simply
by withdrawing their quotations. With a number
of market-makers avoiding or deserting a series

(footnote continued)

(11) The Association would have broad authority to impose on its
own motion restrictions upon transactions in any class or series
of NASDAQ options or transactions in the underlying security as
may be necessary and appropriate to maintain fair and orderly
markets in the public interest. This would enable the Association
to deal with special and unique trading situations the particulars
of which cannot be foreseen in advance.

Analysis, supra, n.343, at 17-22 (footnotes omitted). See also
NASD Plan, supra, n.90, Proposed Article XVI, Section 3, Schedule D,
Part TV, Section 3(a) which, among other things, would increase
the number of registered NASDAQ marketmakers who would be required
to be displaying quotations in the underlying security to ten
prior to the commencement of dual marketmaking activities.

359/ See discussion at 114-115, suora.

066

which had become unattractive, an investor who had
taken on a position in that series might be hard-
pressed to close it out at a price he deemed
reasonable. Dissatisfaction or disillusionment
with loss of liquidity could well spill over from
the NASDAQ options market to the listed options
markets.

Our concern for loss of liquidity is heightened by
the lack of restrictions on withdrawal from market-
maker status as a particular series approaches
expiration or moves into or out of the money.
Although we recognize that no one can guarantee
the continued existence of a secondary market
for a particular series or class of options,
the great strength of the listed options market
has been the liquidity which exchange market-
makers (with their attendant obligations) have
brought to options trading. The NASD proposal
should include features designed to encourage
the development and continuation of a similarly
liquid secondary market. 360/

Taking a slightly different approach, AMEX has stated:

The NASD places great faith in the regulatory
effect of comoetition among market makers, pointing
to the fact that before a dealer is authorized to
make markets in both an option and its underlying
security, there must be a total of at least five
other registered market makers in the underlying
security and at least five registered market makers
in each related options series. It is also true,
however , that it will be extremely simple for a
registered NASD market maker in options to terminate
his registration as such, and it is not clear what
will happen if resignations bring the total number
of reaistered market makers under five. Would the

360/ Letter to George A. Fitzsimmons, Secretary, Securities and

Exchange Commission, from Joseph W. Sullivan, President, CBOE,
dated April 25, 1977, pp. 7-8. See also Letter to George A.
Fitzsimmons from Wayne P. Luthringshausen, President, OCC,
dated May 10, 1977, pp. 3-4.

967

NASD then cease to allow dealers to make markets
in the option, possibly leaving investors without
a market for the securities they have purchased?
Or will the NASD allow the remaining dealers to
continue their dual market making, but without
the active competition relied upon to control
"overreaching" or possible manipulative abuses? 361/

On the other hand, requiring OTC marketmakers to contribute to, and

not diminish, the fairness and orderliness of the OTC markets may result

in burdens on competition that may be deemed unnecessary and inappropriate

and thus inconsistent with the Exchange Act. 362/ Proposals to implement

stringent registration and withdrawal requirements may be viewed in a

similar light. Such requirements may be considered to be burdens on

competition because they may act as barriers to entry into OTC marketmaking,

Moreover, the imposition of such requirements may be inconsistent with a

"fundamental" purpose of the national market system: "to enhance the

competitive structure of the securities markets in order to foster the

risk-taking function of market makers and thereby to provide free market

incentives to active participation in the flow of orders." 363/

361/ AMEX Letter, supra, n.90, at 81-82.

362 See, e^. , Sections 19(b) and 23(a) of the Exchange Act [IS U.S.C.
78s(b) and w(a)] .

363/ Senate Report, supra , n.17, at 14. See also House Reoort, supra ,
n.21, at 50.

968

3. Market Surveillance in the Over-the-Counter Markets
Although transactions in underlying securities traded exclusively
in the OTC markets are not reported as they take place, the NASD Plan
contemplated that OTC marketmakers would be required to time stamp
all trade tickets for transactions in such securities at the time
of execution and to transmit reports of their trading activity to
NASD on a daily or weekly basis. 364/ In addition, all transactions
in securities traded on exchanges are reported daily to NASD. 365/
The NASD Plan also contemplated real-time last sale reporting of NASDAQ
options transactions. 366/

364/ The Plan provided that NASD members would be required to time stamp
all trade tickets on transactions in underlying over-the-counter
securities at the time of execution and to transmit transaction
information to the NASD on such transactions during the course of
a trading day by 6:30 p.m. Eastern Time. NASD members would be
permitted to make such last sale reports on a weekly basis where
their transactions in all underlying over-the-counter securities
did not exceed five hundred shares in any single trading day and
had not exceeded five hundred shares for any five of the previous
ten trading days. This last sale information would be used by the
NASD strictly for surveillance purposes and would not be publicly
disseminated. Aggregate daily volume for each security underlying
NASDAQ options, however, would be released to the public. NASD ^lan,
supra, n.90, Proposed Article XVT, Section 3, Schedule D, Sections
WCL)(d)-(g).

365/ See discussion at 154, supra. See also NASD By-Laws, Proposed
Article XVI, Schedule D, Section 3(g)l(d)-(g) .

366/ NASD Plan, supra, n.90, Proposed Article XVI, Schedule D,
Section 3(g)(1)(a).

969

Under the NASD Plan reports of stock transactions would contain

information regarding the time of execution, the price at which the

transaction occurred, the number of shares bought or sold, and the

identity of the reporting NASDAQ marketmaker, the marketmaker on the

other side of the trade, and the clearing agency for both. Reports

of options transactions would contain comparable information. In addition,

registered NASDAQ marketmaker quotations for NASDAQ stocks and options

would be readily available from the NASDAQ system. Using this information,

NASD would conduct market surveillance activities. As NASD has stated:

We will have sequentially timed transaction reporting

for surveillance purposes of all transactions in

underlying NASDAQ securities. Thus, we will,

among other thinqs, be able to construct an

adequate audit trail and also be able to detect

sequenced changes in options quotes and those in

their underlying securities. We hasten to point

out that the effectiveness of our surveillance

program will be enhanced by the fact that we

will have available to use on a continuous

basis information on activity in both NASDAQ

options and their underlying over-the-counter

securities. As noted previously, sequentially

timed transaction reports on all underlying

securities trades will be submitted daily by

all NASD members effecting such trades. Using

this information, and the real time option

trade reports, the Association's computer will

be able to produce a printout which will show,

side by side and in sequence, daily activity

in NASDAQ oDtions and their underlying securities. 367/

367/ Letter to George A. Fitzsimmons, Secretary, Securities and Exchange
Commission, from Gordon S. Macklin, President, NASD, dated
October 19, 1977, at 4.

970

Further, NASD has suggested that "marketplace competition is, in and of
itself, an effective regulating mechanism," and that "with a significant
number of active participants in the NASDAQ options marketplace, the
potential for manipulation as a result of one or two persons cornering
or dominating the market in a particular security would be substantially
lessened * * * ." 368/

It must be kept in mind, however, that OTC trading in options and
their underlying securities would occur by means of telephone lines
between the offices of upstairs dealers. As a result, there is no trading
crowd or exchange employee to deter, and perhaps observe and report to
exchange officials, trading improprieties. 369/ Moreover, the trade
reporting process is completely manual and totally under the control and
discretion of individual marketmakers, who, if improper activity were to
occur, would be the perpetrators of such activity. 370/ Without the ability
to assure that stock and options transactions are time-stamped as they

368/ NASD Letter, supra, n.90, at 3

369/ The primary method of detecting improper trading practices such
as quote racing, tape racing, and front-running is by means of
complaints from the options trading crowd. See Chapter IV.

370/ See Letter to George A. Fitzsimmons, Secretary, Securities and
Exchange Commission, from Joseph W. Sullivan, President, CBOE,
dated April 25, 1977, at 2. See also Chapter IV.

971

occur and independent means, such as discussions with exchange employees

and officials or members of a trading crowd who witnessed trading

activities or a Drice reporting system that exchange employees operate,

of conducting adequate market surveillance of related stock and options

trading in the OTC markets may be at best difficult, and at worst impossible,

particularly if dual mar ketmak ing is permitted. As CBOE has stated:

[W]e are convinced that the exceptional quantity and
quality of market surveillance deemed essential for
options markets could not be achieved in an OTC
market. A fundamental short-coming of such a market
* * * is that OTC transactions are privately
negotiated instead of occurring in the public forum
of an exchange's market place. Thus, any audit trail
surveillance system that might be developed would have
to rely upon trade information privately reported by
the parties to each transaction, without the checks
that are supolied in an exchange market, such as an
independently-operated price reporting system and the
presence of exchange officials and other exchange
members to detect unusual activities.

This weakness of the OTC market would be especially
detrimental to surveillance of such potential abuses
as intermarket manipulation and misuse of nonpublic
market information, since surveillance of these abuses
calls for knowledge of the precise time that an options
trade takes olace in relation to a transaction in
the underlying stock market. Because the reporting
of OTC transactions is entirely within the control
of the oarticipants, transaction reports could easily
be delayed or altered to conceal improper conduct. 371/

371/ CBOE Letter, suora, n.87, at 48.

972

D. Conclusions

1 . Real-Time Last Sale Reporting and Representative
Bid and Ask Quotations

The absence of a mechanism for reporting and publicly disseminating

information concerning transactions in underlying securities traded

exclusively in the over-the-counter markets as such transactions occur

may make it difficult for market participants to make informed

investment decisions with respect to options that may be traded on

these underlying securities. Without access to information reflecting

the prices at which recent trades in these underlying securities have

occurred and the volume that these trades involved, public investors

nay not be able to determine accurately the intrinsic value that options

that they hold may have or to assess the prices at which they may be

willing to buy or sell options on these stocks. This concern arises

primarily because the price of an option is to a large extent derived

from the price of its underlying security. Additional sources of this

concern, however, are the facts that (i) quotations for stocks traded

exclusively in the OTC market need only be honored for 100 shares

and thus may not themselves supply sufficient information to permit

investors to determine option prices and values accurately, and (ii)

members of the public may only have access to representative bid and

ask quotations for such underlying securities and their related options

973

and, as a result, may be unable to ascertain, for either the options or
their underlying stocks, the best bid and ask price available or the
number of shares or contracts that can be bought or sold at these
prices.

The lack of real-time last sale reporting for stocks traded exclusively
in the OTC markets and the use of representative bid and ask quotations may
also provide OTC marketmakers with market information advantages that
may be inconsistent with '"the maintenance of fair and orderly markets,"

the public interest," and "the protection of investors." 372/ Specifically,
only NASDAQ marketmakers who are the parties to an underlying security
transaction may know that a trade took place and the terms of that
trade. In addition, only market professionals with access to Level
2 or 3 NASDAQ service may have, and be able to trade on the basis
of, information concerning the number and range of bid and ask prices
available with respect to an underlying security traded in the OTC
markets exclusively and its related options. These "differences in
opportunity and treatment" may be deemed to be unfair to the extent
that they exceed "the absolute minimum consistent with the recognized
differences" between NASDAQ marketmakers and NASDAQ Level 2 subscribers

372/ See, e^g., Section HA(a)(l) of the Exchange Act [15 U.S.C. 78k-
1(a)(1)].

40-940 O - 79 - 64

974

and other market oarticioants. 373/ Moreover, if the mechanisms of
an CTC ootions market do not assure, to the greatest extent feasible
that "the highest bidders and lowest offerors do not miss each other
to the disadvantage of both," that market may not be orderly. 374/

NASD has recently stated that it "endorses the conceDt of a national
market system that will feature real-time last sale reporting of trans-
actions in qualified securities." 375/ The Association has also observed:

If it can be assumed that there will be a probable
tie or a correlation between qualifications of
over-the-counter securities underlying NASDAQ
options, we suspect that a resolution of this issue
of real-time last sale reporting can and will be
achieved with start-up of the national market
system. 376/

In this regard, the Commission has stated:

The Commission believes that listed equity securities
included in the consolidated system and a number
of equity securities currently traded exclusively
in the over-the-counter market generally possess
characteristics (including, in most cases, national
investor interest and substantial assets and earnings
histories) which justify their inclusion in the
"qualified" category. The inclusion of securities
now traded exclusively over-the-counter in the qualified
category is contingent, however, upon the implementation

373/ Special Study, supra, n.63, at 14. See discussion at 20, 160-166,
supra.

374/ Id. , at 15.

375/ NASD Letter, suora, n.90, at 21.

376/ Id.

975

of those technical elements of a national market
system necessary to assure that trading in those
securities occurs under competitively fair circum-
stances and in a manner consonant with the principles
of a national market system.

Upon completion of its rulemaking with respect to
designation of those securities qualified for trading
in a national market sytem, it is the Commission's
intention to require last sale information with respect
to completed transactions in all qualified securities
traded exclusively over-the-counter to be included
in the consolidated system, to require quotations
in those securities to be collected and disseminated
in accordance with Rule llAcl-1 under the Act, and
otherwise to ensure that trading in such securities
can be effected by means of, and subject to the
requirements of, the order routing and other systems
which must be developed to realize national market
system objectives. 377/

Because real-time last sale reporting with respect to underlying

securities traded exclusively in the over-the-counter markets is

likely to be obtained as a national market system evolves, a prudent

course may be to defer the initiation of standardized options trading

with respect to such securities until such time as they are included

in the consolidated transaction reporting system and real-time last

sale reporting is available. 378/

377/ January Release, supra , n.176, at 43 (footnotes omitted).

378/ The same rationale would seem to apply to proposals to permit
exchange trading of options related to these stocks. See n.7,
supra .

976

Similarly, the Commission has recently proposed amendments to Rule
llAcl-2 379/ which would prohibit the use of representative bids and
offers with respect to equity securities. 380/ It may be most appropriate
to await the resolution of this rulemaking proceeding before permitting
options markets to develop which would provide representative bid and
ask quotations for standardized options and would rely upon such quotations
for the securities underlying those options. Should the Commission
determine that representative bid and ask quotations should be prohibited
for equity securities, it should also consider whether such quotations
should be prohibited for options.

2. An Over-the-Counter Market For Options Traded on Exchanges
The 1975 Amendments were designed to "facilitate the establishment of
a national market system for securities." 381/ A primary objective of such
a national market system is "the centralization of all buying and selling
interest so that each investor will have the opportunity for the best
possible execution of his order, regardless of where in the system it
originates." 382/ The 1975 Amendments also had "as a fundamental goal the

379/ 17 C.F.R. 240.1lAcl-2.

380/ Securities Exchange Act Release No. 15251, supra , n.318.

381/ Section llA(a)(2) of the Exchange Act [15 U.S.C 78k-l(a) ( 2) ] .

382/ Senate Report, supra , n.17, at 7. See also House Report,
supra, n.21, at 50-51.

1)77

elimination of fragmented markets for securities suitable for auction

trading," 383/ and sought to assure, "fair competition among brokers

and dealers" and, to the greatest extent practicable, economically efficient

execution of securities transactions in the best available market without

the participation of a dealer. 384/ The development of an OTC market

for standardized options already traded on exchanges should be considered

in light of various statutory objectives.

First, in order to be successful, OTC markets for options traded
on exchanges would have to attract option orders that are presently
directed to the options exchanges. If the OTC markets capture a significant
portion of this order flow, the financial well-being of the secondary
stock exchanges that also permit options trading may be threatened,
and recent initiatives toward the establishment of a national market
system may be jeopardized. 385/

Second, in OTC markets for listed options, each OTC marketmaker trading
the multiply traded classes would in effect become a separate market for
that class and would have the ability to trade with his customers
without exposing these customer orders to other market participants.

383/ Id., at 17.

384/ Section llA(a)(l) of the Exchange Act [15 U.S.C. 78k-l(a) (1) ] .

335/ See discussion at 86-92, supra .

978

Consequently, the markets for listed options may become more fragmented,
and it may become more difficult to assure that the orders of public
investors for multiply traded options classes are exposed to the full
forces of supply and demand, obtain the best execution available without
the intervention of a dealer, and realize "the protections and benefits
of [an] auction market." 386/

Third, the task of achieving the centralization of buying and selling
interests through linking of market centers as the Exchange Act envisions
may become more complex. The need to establish linkages with the offices
of each OTC marketmaker trading an options class that is traded on an
exchange, 387/ to reconcile the trading rules and price reporting techniques
of the OTC markets with those of the exchange markets, and to assure maximum
limit order protection and opportunities for the interaction of all
orders for multiply traded classes may contribute to this complexity.

Finally, OTC options marketmakers may have market information and
other advantages that may be deemed unfair when compared to the competitive
position of options marketmakers on the exchange floors. OTC marketmakers,

386/ Senate Report, supra, n.17, at 17. See discussion at 8-12,
supra.

387/ Should the Commission, after weighing the considerations discussed
herein, decide to permit the development of OTC markets for exchange
listed options at this time, the Commission should assure that such
markets are included in any plans to establish market linkages and
order routing systems for multiply traded options classes. See
discussion at 71-86, supra .

979

for example, may have access to, and be able to trade against and on the
basis of, retail customer orders for multiply traded options classes and,
in the event that complete segregation of stock and options trading is
not required in the OTC markets, their underlying securities. In
addition, these marketmakers may be able to trade with their customers
without exposing their customer orders to other market participants
and without being subject to exchanges auction trading rules affording
limit order protection. 388/ Moreover, OTC options marketmakers may
not be subject to the obligations that Commission and exchange rules
impose upon options exchange marketmakers. 389/ Permitting dual market-
making in the OTC markets without allowing comparable integration
on exchange floors for multiply traded classes and their underlying
securities may, of course, disadvantage options exchange marketmakers
still further.

On the other hand, Congress considered a "healthy, highly competitive
system of marketmakers" to be "essential to an efficient national market
system" and stated that "encouragement should be given to all dealers
to make simultaneous markets within the new national system." 390/

388/ See discussion at 168-173, supra.

389/ See Section 11(b) of the Exchange Act [15 U.S.C. k(b)]; 17 C.F.R.
240.11 b-1; and discussion at 185-190, supra.

390/ Senate Report, supra , n.17, at 14.

980

In addition, the 1975 Amendments require the Commission to assure "fair
competition * * * between exchange markets and markets other than exchange
markets" 391/ and "to refrain from imposing, or permitting to be imposed,
any new regulatory burden on competition 'not necessary or appropriate in
furtherance of the purposes' of the Exchange Act." 392/

3. The Integration of Trading of Options and Their

Underlying Securities in the Cver-the-Counter Markets

Dual marketmaking may be the only method of integrating the trading of

options and their underlying securities in an over-the-counter environment.

Accordingly, degrees of improvements in market quality or efficiency and

the extent of trading integration may be less relevant when evaluating

integration proposals pertaining to CTC markets than when evaluating

exchange integration plans. 393/ Because the CTC markets are composed of

numerous competing dealers, each of whom has exclusive access to, and

knowledge of, some portion of any limit orders that may be present

in the marketplace and each of whom may attract a significant portion

of the orders for securities he is trading, considerations concerning

the competitive position and the marketmaking system of the market

391/ Section HA(a)(l) of the Exchange Act [15 U.S.C. 78k-l (a)(1)] .
392/ Conference Report, supra, n.18, at 94.
393/ See discussion at 99-102, 122-125, supra .

981

center making a proposal to permit integration in the OTC markets
may be less relevant. In all other respects, analysis of OTC market
integration plans may be conducted within the same framework as those
suggested for exchange plans: 394/ improvements in the quality of the
markets for options and their underlying securities that might be
derived from dual marketmaking must be balanced against the market
information and competitive advantages that dual marketmakers may
have over other market participants, additional incentives and oppor-
tunities for engaging in manipulative and other improper trading practices
that may be created, and increased difficulties in conducting adequate
market surveillance that may result.

Three more specific points should be kept in mind when evaluating
OTC integration orooosals. First, the absence of real-time last sale
reoorting for underlying securities traded exclusively in the OTC markets,
the use of representative bid and ask quotations for underlying securities
and their related options, and the ability to trade with, and on the
basis of, customer stock and option orders and inquiries may provide OTC
dual marketmakers with market information and competitive advantages
and opportunities to engage in improper trading activities that exceed
those of other OTC market participants. Second, the fact that market

394/ See discussion at 139-142, supra

982

surveillance in the OTC markets is, of necessity, based exclusively
upon accurate time-stamping and reporting of transactions by NASDAQ
marketmakers may make OTC market surveillance difficult. Because trading
takes place in the offices of market professionals and transaction reports
may not be subject to independent verification by a self-regulatory
organization employee or official, the members of a trading crowd, or
a price reporting system controlled by the NASD or an exchange, the
precision needed to identify the times that stock and options transactions
occurred may not be obtainable, and it may be relatively simple to
disguise improper trading to avoid detection. Finally, the extent
and nature of any marketmaking obligations and the ease with which
NASDAQ dual marketmakers may enter and suspend quotations should be
considered in connection with any OTC dual marketmaking proposal.
While the 1975 Amendments contemplated that the "competitive structure and
incentives" to engage in marketmaking activities in a national market
system "should supplement, and ultimately may be able to replace,
most affirmative requirements to deal imposed by regulation" 395/
and directed the Commission "to refrain from imposing * * * any new
regulatory burden on competition 'not necessary or appropriate in
furtherance of the purposes' of the Exchange Act," 396/ the Commission

395/ Senate Report, supra, n.17, at 14.
396/ Conference Report, supra, n.18, at 94.

983

may wish to satisfy itself that an OTC options market will be suffi-
ciently liquid on a regular basis so that it "does not 'fold up' when
the pressure on dealers becomes too heavy." 397/

VI. TOE NSW YORK STOCK EXCHANGE AND STANDARDIZED OPTIONS TRADING

The New York Stock Exchange submitted a plan in June, 1977 to permit
the trading of standardized options on the NYSE floor. 198/ NYSE proposed
to implement an options trading system which would be similar to that
of the CBOE. Under the NYSE Plan, OCC would be the issuer and primary
obligor of option contracts listed on NYSE. The marketmaking function
on the NYSE floor would be performed by competing options marketmakers .
As on all options exchanges utilizing a competing marketmaker system,
the transactions of each marketmaker would be required to be "reasonably
calculated to contribute to the maintenance of a fair and orderly
market," and no marketmaker would be permitted to "enter into transactions
or make bids of offers that [would be] inconsistent with such a course
of dealings." 399/ The marketmakers also would be subject to trading

397/ Special Study, supra , n.63, at 15.

398/ NYSE Plan, supra , n.5.

399/ NYSE Plan, Proposed Rule 757(f). See also, CBOE Rule 8.7(a); MSE
Article XLVII, Rule 6(a); PSE Rule VI, Section 79(a). In addition,
with respect to each class of options in which he would have been

(footnote continued on next page)

984

rules analogous to those on other options exchanges utilizing a competing

marketmaker system. Limit orders would be handled and executed by

Order Book Officials employed by the exchange, and such Officials

would not be permitted to trade for their own accounts.

NYSE proposed to commence its options program by listing options on

twenty-five underlying securities. NYSE indicated that many of these

underlying securities are listed and traded on NYSE and that it intends

to list classes and series of options, including puts, that are already

listed and traded on one or more option exchanges. In fact, NYSE has

stated :

[A]ny new entrant into the options business must be able
to list and trade existing options classes if it is to
attract sufficient investor interest to justify the cost

(footnote continued)

registered, each NYSE options marketmaker would have had "a continuous
obligation to engage, to a reasonable degree under the existing
circumstances, in dealings for his own account when there exists,
or it is reasonably anticipated that there will exist, a lack of
price continuity, a temporary disparity between the supply of and
demand for a particular option contract, or a temporary distortion
of the price relationship between option contracts of the same class."
NYSE Plan, Proposed Rule 757(f). See also CBOE Rule 8.7(b); MSE
Article XLVII, Rule 6(b); PSE Rule VI, Section 79(b). The NYSE
Plan also would permit "competitive traders" to trade options for
their own accounts on the NYSE floor. When present in a trading
crowd or called upon by a floor official of the NYSE, a competitive
trader would have marketmaking obligations identical to those of
an NYSE options marketmaker. NYSE Plan, supra, n.5, Proposed
Rule 758(c).

985

of establishing and maintaining an efficient, effectively

regulated options market. * * * Apart from the obvious

inequity in any approach that would exclude the NYSE

from listing and trading standardized options that are

traded on one or more other exchanges, it would not

be economically feasible for the NYSE to limit its options

trading program exclusively to options on securities

which are not subject to options trading elsewhere.

The most attractive securities for options trading have

already been selected by the existing options exchanges. 400/

Most of the NYSE options would be traded in a room physically

separated from the NYSE equity trading floor by a ceiling-high solid wall,

Since the options room, however, would not have contained sufficient

space for the trading of options on all twenty-five underlying securities,

NYSE planned to convert one post in the main equity trading room to an

options trading post. NYSE represented that no option would be assigned

to the options post in the main equity trading room if the underlying

stock would also be traded in that room. The NYSE Plan, however, did

not contain provisions which would restrict NYSE stock specialist and

registered stock marketmaker access to the NYSE options trading floor,

or NYSE options marketmaker access to the NYSE stock floor. Moreover,

the Plan did not contain provisions which would restrict NYSE stock

specialists and registered stock marketmakers from trading options

on the NYSE floor. 401/

400/ NYSE Letter, supra, n.85, at 7.

401/ Proposed NYSE Rule 757 would prohibit a registered NYSE options

marketmaker from trading other securities on the NYSE floor. Proposed
NYSE Rules 105 and 758, however, would permit NYSE stock specialists

(footnote continued on next] page)

986

Since the NYSE Plan contemplated an expansion of multiple
trading of standardized options and a greater degree of integration
of trading of options and their underlying securities than presently
exists, the concerns and considerations previously set forth with
resoect to these two subjects should be taken into account when
evaluating this, or any similar, proposal. 402/ The predominant
position of NYSE in the markets for underlying securities, however, may
intensify some of these concerns and place some of these considerations
in different perspective than multiple trading and integration proposals
that other exchanges may submit. This section will discuss the extent
and nature of NYSE dominance in the markets for underlying securities
and the impact that this dominance may have upon the factors that should

(footnote continued)

to trade options with respect to their specialty stocks and NYSE
registered stock marketmakers to trade options for their own account.
See Securities Exchange Act Release No. 12924, supra , n.224, and
discussion at 144-148, supra. See also Letter to George A. Fitzsimmons,
Secretary, Securities and Exchange Commission, from James E. Buck,
Secretary, NYSE, dated July 13, 1978. More specifically, the NYSE
Plan did not contain provisions prohibiting (i) the partners or
associates of an NYSE options marketmaker from trading underlying
securities, or being a stock specialist on the NYSE floor, (ii)
the partners or associates of a registered stock specialist from
becoming a "competitive trader" and trading options with respect
to a specialty stock, or (iii) a registered stock marketmaker,
or his partners or associates, from acting as an options marketmaker
or competitive options trader.

402/ See Parts III and IV of this chapter, supra.

987

be considered in connection with an evaluation of an NYSE oroposal to
begin standardized options trading.

A . The Predominant Position of the New York Stock Exchange
in the Markets for Underlying Securities

1 . NYSE Market Share

In 1977, NYSE accounted for 79 per cent of the share volume and 84
per cent of the dollar volume for securities traded on exchanges. 403/
AMEX, by contrast, was resoonsible for 9.3 per cent of share volume and
4.6 per cent of the dollar volume during the same year. 404/ In addition,
NYSE accounted for 85.8 per cent of the volume of all trading in stocks
listed on NYSE in that year. 405/ By comparison, NYSE's nearest competitor
for multiply listed stocks captured less than 5 per cent of the consolidated
share volume for these stocks. 406/

All but two of the 218 stocks that are currently subject to stand-
ardized ODtions trading are listed on NYSE. Further, "NYSE is considered

403/ Securities and Exchange Commission Statistical Bulletin, Vol. 37,
No. 2 (February, 1978), at 17.

404/ Id.

405/ Id., at 35.

406/ NYSE, 1977 Annual Report of the Quality of Markets Committee, Exhibit
E. See also CBOE Letter, supra, n.87, at Table A. A copy of this
table is provided as Table 22.

988

the 'primary market' for each of them," 407/ and accounts for a mean
of 86.4 per cent of the consolidated share volume in these stocks. 408/
CBOE also estimates that "approximately 440 stocks currently meet
Commission-approved criteria for standardized options trading" and
that NYSE is the "primary market for all but two of them," attracting
more than 80 per cent of the mean proportion of dollar and share
volume and number of trades on each of these stocks. 409/

In light of these data, there is little doubt that NYSE is "by
far the dominant market in the securities industry and has achieved an
overwhelming concentration of trading in practically all of the underlying
stocks which are eligible for exchange ootions trading." 410/

2. NYSE Financial Resources
As a result of this predominant position among exchange markets and
markets for NYSE-listed stocks, NYSE has revenues and resources at
its disposal which exceed those available to other exchanges. Total NYSE

407/ CBOE Letter, supra, n.87, at 30.

408/ Letter to Richard Weingarten from James W. Fuller, supra, n.293.

409/ CBOE Letter, supra, n.87, at 30 and Table B. A copy of CBOE's
Table B is provided as Table 23. See also AMEX Letter, supra,
n.90, at 12.

410/ AMEX Letter, supra , n.90, at 3.

989

revenues in 1977, for example, were $118,962,000 and pre-tax income was
$10,747,000. 411/ Total AMEX revenues were $36,801,000 and pre-tax income
was $1,246,000 during the same year. 412/ CBOE, by contrast, had total
revenues of $12,295,000 during 1977 and a pre-tax loss of $580,000. 413/
PHLX, on the other hand, the smallest of the options exchanges in terms of
revenues had $4,978,000 in total revenues and $132,000 in pre-tax income
in that year. 414/ Similarly, NYSE had total assets of $107,465,000 in
1977 whereas AMEX had total assets of $26,996,000, CBOE of $23,331,000,
and PHLX of $30,514,000. 415/

Thus, it is clear that NYSE has "vastly superior financial resources"
relative to all other exchanges. 416/

411/ Staff Report on the Securities Industry in 1977, Directorate of

of Economic and Policy Research, Securities and Exchange Commission,
(May 22, 1978), Exhibit 22. It should be noted that NYSE maintains
that its total revenues are $87,132,000 and that its revenues before
taxes are $9,451,000. NYSE Letter, supra, n. 85, at 14. See also
CBOE Letter, supra, n.87 at Table C. This table contains comparative
financial information for selected self-regulatory organizations and is
provided as Table 24.

412/ Id.

413/ Id.

414/ Id.

415/ Id.

416/ AMEX Letter, suora, n.90, at 20.

40-940 O - 79 - 65

990

3 . NYSE Marketroaking Resources

NYSE specialists have accumulated resources which exceed those of
marketmakers on other exchanges. While the exact amount of capital
available to such firms "is rather difficult to pinpoint because it
may change significantly within rather short periods of time and because
many of such firms may emoloy their capital in different lines of
business,1' 417/ NYSE has estimated that the combined buying power of
its 62 specialist units at December 31, 1977 was $738,000,000. 418/
Further, the total equity capital of 61 NYSE firms classified as
primarily engaged in marketmaking and trading was between $430,000,000
and $520,000,000 during most of 1976 and 1977. 419/

Although such figures are not precisely comparable, equity figures
that the Options Study derived with respect to the cleared accounts of
options marketmakers provide a basis for placing these NYSE marketmaking
resources in perspective. For example, the equity in such accounts on all
exchanges was $81,172,000 and $84,310,000 on December 31, 1976 and 1977
respectively. 420/ More specifically, the equity in such accounts on

417/ AMEX Letter, supra, n.90, at 22.

418/ NYSE Annual Report, 1977, at 7.

419/ Staff Report on the Securities Industry in 1977, supra, n.411
at Exhibit 9.

420/ See Chapter VII, Exhibit E, Table 1.

991

CBOE was $53,963,000 and $45,784,000 and on AMEX was $23,301,000 and

$34,524,000 on these dates. 421/

Additional resources are also available to NYSE specialists. As

CBOE has observed:

The power of NYSE's specialists is compounded
by the fact that some of them control a larqe number
of books. For example, the largest NYSE specialist
firm makes markets in 132 common stocks (8% of the total
number listed on the NYSE) and the next largest makes
markets in 72 common stocks. Further, many of the
larger soecialist firms clear books other than their
own. This control over numerous books gives the
NYSE specialist firm a further comoetitive advantage
in any multiple trading contest in a particular
security, since it is in a position to attract order
flow in the multiply-traded security by offering
discounts on brokerage in its other securities and/or
in the multiply- traded security itself. 422/

4. Additional NYSE Resources

NYSE has other resources that may contribute to, be responsible

for, and result from its position as the nation's predominant securities

market. AMEX, for example, has pointed out:

To fully appreciate the significance of the NYSE's
dominance of the securities markets it is necessary
to understand * * * the relationship between the
NYSE and its member firms, its listed companies and
ultimately the nation's investors.

421/ Id., at Tables 2 and 3.

422/ CBOE Letter, suDra, n.87, at 34-35 (footnote omitted).

992

Most brokerage firms of any significant size
have their execution capability centered on the
NYSE. This involves more than just personnel,
although clearly most firms do have their largest
complement of brokers and support personnel
located on the floor of the NYSE. Internal
communications networks and sophisticated order
routing systems have largely been designed with
an eye to transmitting orders to and obtaining
information from the NYSE floor. Operational
and post-trade procedures of brokerage firms
are largely oriented to NYSE requirements and
systems. The NYSE has attracted to its floor
the largest and by far the most highly capitalized
corps of market makers.

Nearly 450 of the "Fortune 500" industrial
companies are listed on the NYSE. * * *
The prominence of the NYSE has been attractive
to many companies that have grown and sought
to achieve greater national recognition. * * *
Over the past forty years, in excess of 60
companies traded on the Amex have transferred
to the NYSE. It has been the Amex's experience
that such transfers were not normally motivated
by dissatisfaction with the market for their
securities on the Amex but rather that they
expected to gain added recognition through
the broader exposure given by the financial
press to NYSE companies and to achieve greater
prestige by being listed on the nation's most
prominent exchange.

The prominence of the NYSE market and its
listed securities serves to sustain and
strengthen its dominance of the securities
markets. NYSE stock tables receive much broader
exposure in the financial press than those of
any other exchange. Its securities have a
much greater following among registered
representatives and analysts. Many investors,
particularly institutions, focus their invest-
ment interest exclusively on NYSE listed

993

securities and often invest all or substantially
all of their funds in such securities. * * *

Perhaps no private institution in this
country plays as influential a role in its
particular area of the economy as that of the
NYSE in relation to the securities industry. 423/

Similarly, CBOE has pointed out that NYSE "possesses various intangible

resources" which it has developed over the years, 424/ stating:

[T]he NYSE is the prime beneficiary of the "primary
market" concept. Ibis term is not merely descriptive
of the dominance in stock trading that the NYSE has
achieved; it also contributes heavily to that dominance,
since, * * * in the absence of the facilities and rules
of a truly competitive national market system, customer
order flow is generally directed to the market that is
regarded as "primary" and thereby reinforces that status.

Having grown and prospered over a long period in a
monopoly environment, the NYSE has gathered a large
and powerful membership, which accounts for the over-
whelming preponderance of the brokerage business in
equity securities in the United States. * * *

In addition, the NYSE long ago established, and
has insisted on maintaining, primary self-regulatory
authority over all its member firms, regardless of
their size, location, other activities or other
self-regulatory memberships. Under Rule 17d-l and
the plans that have been filed under Rule 17d-2,
the NYSE is the designated examining authority for
virtually all of its member firms, even though many
are also members of other exchanges. 425/

423/ AMEX Letter, supra, n.90, at 9-14 (emphasis in original)
( footnotes omitted) .

424/ CBOE Letter, supra, n.87, at 31.

425/ Id., at 31-32 (footnotes omitted).

994

B. Potential NYSE Predominance of the Standardized
Options Markets

The predominant position of NYSE in the markets for underlying
securities may provide it with competitive advantages that the options
exchanges do not possess and may substantially assure that NYSE would
come to be the predominant options market in the long run. These
advantages will be discussed in this section and should be kept in mind
in connection with any proposal to permit the trading of options on
the NYSE floor that NYSE may submit.

1. NYSE and the Primary Market Designation
NYSE is the primary market for virtually all stocks traded on its
floor. In 1977, for instance, NYSE attracted more than 90 per cent of
the consolidated share volume in approximately 70 per cent of its
multiply traded stocks, and captured more than 70 per cent of the market
in all but 4 per cent of its issues. 426/ As a result, NYSE may be
"automatically considered by a large part of the exchange community to be
the primary market in practically all securities that become listed there,
regardless of the quality or depth of market that may be made elsewhere." 427/
In this regard, AMEX has stated:

426/ NYSE, 1977 Annual Report of the Quality of Markets Committee,
Exhibit E. See Table 22.

427/ AMEX Letter, supra, n.90, at 17-18 (footnote omitted).

995

Brokerage firms and investors alike who have traditionally
identified the NYSE market with the securities of most
major corporations that are the subject of options trading
will most likely transfer that primary market identification
to the options as well. The great prominence and prestige
of the NYSE as well as the vast influence that it exercises
over the securities industry will tend to reinforce this
strong predilection towards its market. 428/

2. NYSE Facilities Advantage

Because most brokerage firms do a substantially higher volume of

business on NYSE than on any other exchange, most of these firms have their

execution capability and personnel "centered" on NYSE. 429/ Similarly,

their internal communications networks and order routing systems are

"oriented to the NYSE market." 430/ This "concentration of personnel

and facilities," as AMEX has pointed out, may represent "a very

substantial commitment by [NYSE] member firms to the NYSE market and

[may] serve as an almost irresistible force in attracting options order

flow to that exchange at the expense of other markets." 431/ Along the

same lines, CBOE has noted:

The NYSE [may] be likely to obtain order flow benefits
from the fact that over the years the securities industry
has concentrated resources in New York for stock trading

428/ Id., at 16.
429/ Id., at 18.
430/ Id.
431/ Id.

996

which also could be used to handle options business;
most member firms have more floor members and more staff
on the floor of the NYSE than elsewhere; and many firms
have developed close relationships with NYSE specialist
units and their personnel. Further, many NYSE floor
members, who are influential in member firms controlling
substantial order flows, would have both the incentive
and frequently the power to direct their firms' options
order flow to the NYSE. 432/

3. NYSE Advantage With Respect to Combined Orders
As the primary market for virtually all underlying securities, 433/
NYSE may have a distinct advantage when competing to attract orders that
necessitate the purchase or sale of an option and a simultaneous trans-
action in its related stock. For example, because the price of the
option portion of these "combined orders" will depend in large part
upon the price of the underlying stock at the time that the option
order is entered, brokers executing such orders may be more likely
to obtain the best prices available for both parts of the order if
they can evaluate market conditions for both securities on the exchange
floor that is likely to determine the price of the underlying stock. In
addition, it may be more economical for a brokerage firm to send a
combined order to one floor broker and one exchange floor rather than

432/ CBOE Letter, supra, n.87, at 39.

433/ See discussion at 209-210, 216, supra.

997

to two, as is now the case. Should such economies exist, the most

likely floor to receive the order may be the primary stock exchange

floor because stock prices, and, as a result, options prices, are

likely to be most accurately assessed there. In this connection,

AMEX has observed:

If the market center which is considered the primary
market for the underlying stock is also able to provide
a market for the option as well, it will have a very
significant advantage in attracting both sides of the
order. Ibis will not only give the NYSE an added edge
over any competing market center in seeking options
order flow but also will help to further entrench its
already overwhelming position of dominance in the area
of equities trading. Other exchanges will be unable
to effectively compete for this type of order even if
they do Drovide a market in both the option and the
underlying stock because experience demonstrates that
most firms send the equity order to the primary market
(the NYSE) and, therefore, the ODtion order is likely
to be sent there as well. 434/

4. NYSE Financial Resources
NYSE's superior financial resources and revenue flow 435/ may also
provide NYSE with a competitive advantage over other options exchanges.
Its accumulated capital may enable NYSE "to far out-spend other exchanges
in an effort to initiate and promote its options Drogram." 436/ In

434/ AMEX Letter, supra, n.90, at 19-20.
435/ See discussion at 210-212, supra.
436/ AMEX Letter, supra, n.90, at 20.

998

addition, NYSE's income flow from stocks and other securities may
"provide the means for subsidizing the operation of its options market
and permit the charging of fees below those of other exchanges in an
effort to win order flow." 437/

AMEX and CBOE have noted the competitive advantages that NYSE's sub-
stantial financial resources may provide. AMEX illustrated these advantages
with the following example:

[T]he NYSE plan provides for the use of "order book
officials" who will be exchange employees and who
will be responsible for maintaining the limit order
books in options, executing agency orders left on
the books by brokers, quoting the markets, and in
general controlling the trading crowds. The NYSE
can, if it chooses, compensate its order book
officials out of funds derived from existing
sources of revenue and charge minimal fees (or
no fees at all ) for the services which they
perform. These services on most other exchanges
are performed by members who must charge a fee
to cover their expenses and make a reasonable
profit. Even if other options exchanges were
to adopt the "order book official" concept, few,
if any, would have existing revenue sources which
could be used to subsidize the providing of such
services, and would, therefore, have to impose
fees sufficient to cover the cost of providing
the services. If the NYSE determined to adopt
this competitive scheme, the lower cost of executing
options transactions (particularly limit orders)
on its floor would provide it with a formidable
advantage over other exchanges, an advantage
which would surely result in the re-direction
of order flow to its floor. 438/

437/ Id.

438/ Id., at 20-21.

999

Similarly, the CBOE has stated:

[T]he NYSE would start an options program with a
capital base and revenue flow derived from its
dominant position in stock trading that competing
exchanges could not hope to match. The increasing
importance of very costly automated systems in
order handling and market surveillance would be
likely to make this great disparity in resources
decisive in any future competitive struggle. For
example, the NYSE might well be able to avoid
assessing a user charge for any new order handling
system (or to impose a much lower charge) by directly
or indirectly subsidizing the capital and
operational costs with revenues derived from its
stock market. In contrast, competing options
exchanges, which depend on transaction fees as
their major source of revenue, would likely have to
impose charges for the use of such systems.

The NYSE could also use its unmatched financial
resources in a variety of less obvious but equally
anticompetitive ways. For example, the NYSE and
its floor members would undoubtedly seek * * * to
obtain experienced options personnel, trained at
the expense of other options exchanges and their
floor members, by offering inducements that the
latter would be financially unable to match. 439/

5. NYSE Marketmaking Resources and Advantages
The financial resources of NYSE stock specialists and market-
makers 440/ may contribute to, and ultimately become, the competitive

439/ CBOE Letter, supra, n.87, at 38. See also discussion at 227-229,
infra.

440/ See discussion at 212-213, supra.

1000

advantage of an NYSE ootions market. To the extent that NYSE stock

marketmaking resources are allowed to be used in connection with NYSE

options marketmaking activities, 441/ NYSE options marketmakers may

have access to financial resources which would exceed those available

to options marketmakers on other exchanges.

In this regard, AMEX has observed:

The vast financial resources of NYSE floor-
oriented firms could be used in several ways to
wage competitive warfare. For example, substantial
amounts of capital and marketmaking talent could
be concentrated in specific options where the
competitive battle was most intense. Once the
redirection of order flow had resulted in the
NYSE floor being recognized as the primary market
for those particular options, the capital and
marketmaking capability could be focused on another
group of options. One by one, or group by group, the
NYSE floor would become the dominant market in the
options it chose to list, and once it achieved primary
market designation in an option, experience demonstrates
it would be nearly impossible for any other exchange
to dislodge it.

The "flocking" of market makers to the areas where
competition is the most intense would not require formal
agreements or even oral understandings. It would be
very apparent to the NYSE market makers that by
concentrating their efforts and sacrificing immediate
rewards, the resulting flow of business once that
market had been established as dominant in options
would be immensely rewarding to all. If individual
market makers on different exchanges had roughly
comparable amounts of financial resources and no

441/ See discussion at 207, and n.401, supra.

1001

exchange had any overriding advantages such as
those described above, then this kind of "pull and
tug" would be considered the very essence of
competition. However, given the magnitude of the
resources available on the NYSE floor, combined
with the many other advantages which can be
brought to bear by the NYSE in the competitive
fray, it is very likely that the countermeasures
by market makers on other exchanges to retain
order flow would prove in the long run to be
largely ineffectual. 442/

More generally, CDOE has pointed out that revenues that NYSE stock market-
makers generate from their stock trading may be used to "temporarily
[subsidize NYSE options marketmaking] at below-cost pricing levels or
to maintain minimal spreads between bid and offer so as to enable the
NYSE to attract order flow," 443/ and that NYSE stock specialists who
also perform clearing functions may be able to provide capital and
credit resources to NYSE options marketmakers whose accounts they clear
exceeding those available to other options marketmakers. 444/

It must also be kept in mind that virtually every stock traded on
NYSE is assigned to a unitary specialist who has combined dealer and agency
functions and essentially exclusive control of and access to the limit order
book for that stock. Further, specialist firms may control the limit

442/ AMEX Letter, supra, n.90, at 24-25.

443/ CBOE letter, supra, n. 87, at 38. .

444/ Id., at 39.

1002

order books for numerous stocks. 445/ Accordingly, there may be "temptations

and opportunities" for NYSE stock specialists and other market participants

to engage in "reciprocal practices" designed to attract options order

flow to the NYSE floor. 446/ NYSE stock specialists, for example, may be

able to "give brokerage discounts with respect to their specialty stocks

to induce customers to bring their options orders to the NYSE's options

floor." 447/

Finally, two other significant marketmaking advantages may accrue

to NYSE marketmakers in an NYSE options market as a result of NYSE's

predominant position in the markets for underlying securities. CBOE

described these advantages as follows:

Effective market-making in options depends on the
use of stock positions to hedge options positions.
An options market-maker who has access to the stock

445/ See n.422 and accompanying test, supra.

446/ CBOE Letter, supra, n.87, at 40.

447/ Id., at 38-39. In this connection, CBOE stated:

For example, according to published reports, during
recent competition between the NYSE and the AMEX
concerning a particular stock, the NYSE specialist
discounted its brokerage fee by 25% in that stock
and all 29 of the other stocks in which it made
markets, and a number of brokerage firms directed
their order flow to the NYSE rather than the AMEX
(on which the stock had previously been solely
listed) as a result.

Id., at 35.

1003

market on a cheaper or more efficient basis than a
competing market-maker enjoys a substantial com-
petitive advantage. Further, information as to
market activity and developments on the NYSE stock
floor is of much greater utility in options trading
than is comparable information as to any other stock
floor. As NYSE market -makers or other traders move
back and forth between its options and stock floors —
a practice which does not appear to have been
prohibited in the withdrawn NYSE proposal 448/ — and as
they otherwise develop communications to both

448/ Regarding NYSE's representation that NYSE listed options and their
underlying securities would be traded in separate rooms, AMEX has
observed :

The NYSE proposed to trade most of these original twenty-
five options in a room adjacent to but "physically separated
from the equity trading floor by a ceiling-high solid
wall." However, since this room does not contain sufficient
space for trading all of the original twenty-five options,
one post in the equity trading area is also to be converted
to an option trading post. The NYSE has represented to the
Commission that no option would be assigned to the option
post in the "main equity trading room" if the underlying
stock is also traded in that room. As to exactly where
these underlying stocks are to be traded is unclear, but
presumably they would be traded in a space adjacent and
accessible to the "main equity trading room". Actually,
the trading floor of the NYSE consists of several contiguous
areas, all of which are completely open to one another
(without walls or barriers in between) and all such areas
are fully accessible to all floor members and support
personnel. It would therefore appear that purported
distinctions between a "main equity trading room" and
other trading areas are meaningless and that all of the
NYSE's trading areas combined (including the so-called
"options room") must be considered a single trading floor.

In any event, it is clear that the NYSE does not intend
to limit its options trading program to twenty-five
options. As it adds more options it will presumably

( footnote cont inued on next page )

1004

floors which would not be available to all, they
would have tremendous communications and informational
advantages over market-makers on other exchanges. 449/

With respect to these communications and informational advantages,

AMEX has observed:

It is not necessary for a market maker or floor trader
to simultaneously observe both markets personally (al-
though that most likely would be possible on the NYSE
floor to the extent that options are traded in its equity
trading area) in order to achieve such trading advantages.
By being physically present in the trading crowd for an
underlying stock, a individual can gain valuable market
information which he can promptly use in making decisions
concerning his trading activities in the related option,
and he can imolement those decisions prior to the
oublic dissemination, if any, of the market information
he has obtained.

[Moreover,] individual members need not act alone in order
to take advantage of market information gained on the floor
of an exchange which conducts both options and equities

(footnote continued)

have to utilize more space on its equity trading
floor or expand such trading floor by incorporating
additional space adjacent thereto. Moreover, even
though most of the original twenty- five options are
to be traded in a separate, adjacent room, it is our
understanding that the NYSE contemplates that all
specialists, market makers, floor traders and floor
brokers will have equal and unlimited access to both
the equity trading area, the "option room" and any
other room or area in which either equities or options
may be traded in the future. The "ceiling-high solid
wall" will apparently be quite permeable, or else
readily avoidable by some easily accessible detour.

AMEX Letter, supra, n.90, at 27-29.

449/ Id., at 40 (footnote omitted).

1005

trading. Through cooperation between partners in the
same firm, or between independent members who find it
convenient and profitable to engage in joint trading
efforts, the market intelligence gained from observing
the trading crowd in an underlying stock can be trans-
mitted speedily and effectively to a floor trader or
market maker standing by at the option post, and vice-
versa. Direct oral communications, use of hand signals,
sending messages via clerks — these and other means of
intra-floor communications will assure that market
information which can be of value in making trading
decisions is speeded from one partner to another,
or from one participant in a joint trading venture to
another such participant, so that it can be acted upon
before the information is disseminated publicly or
its impact has been dissipated in the market. 450/

6. NYSE Ability to Attract Talent

In view of NYSE's predominant position in the securities markets generally

and the resulting competitive advantages that it may enjoy if permitted to

initiate an options trading program, NYSE may be able to attract marketmaking

and other talent from other options exchanges. In fact, since the number

of individuals with knowledge of options marketmaking and exchange operations

may be limited, and since training new personnel may be costly and time-consuming,

NYSE may be compelled to recruit experienced personnel from the other

options exchanges- when building the foundation for its options marketplace.

With regard to this possibility, AMEX stated:

A matter of major concern for other exchanges is
the fact that it would be possible for the NYSE and
its floor members, through offering high salaries,

450/ AMEX Letter, suora, n.90, at 29-32.

40-940 O - 79 - 66

1006

bonuses, offers of partnership and other inducements,
to lure away the most knowledgeable and experienced
ootions personnel from other exchanges. This would
not necessarily be confined to lower echelon employees,
but most likely would be concentrated in the area of
experienced market making talent. As the best market
makers were induced to transfer to the floor of the
NYSE, either as a result of attractive offers to join
existing firms or through arrangements by clearing
firms to provide large amounts of financing, the
options markets on other exchanges would deteriorate,
thus further impacting adversely on their ability
to compete. There would be practically no way in
which such "pirating" could be combatted when all
of the other advantages that could be offered by
the NYSE and its floor members are considered.

Another factor which could have a substantial
impact on the shifting of financial resources and
personnel is the fact that many firms which are
engaged in market making activities on existing
options exchanges are also members of the NYSE.
For example, 17 Amex specialist firms are members
of the NYSE and several of them already engage in
marketmaking activities on that floor. If any
significant number of these firms determined it
was more advantageous to trade options on the
NYSE floor because it is the primary market for
all of the underlying stocks, they could very
easily shift the bulk of their capital and any
needed personnel to that floor , and the result
could spell virtual disaster for the Amex options
program. 451/

While the scope and effect of NYSE's ability to attract experienced

ootions marketmakers and other personnel are, at best, difficult to

project, it may be relevant to consider that the six NYSE's specialist

451/ AMEX Letter, supra , n.90, at 23-24. See also n.439, supra ,
and accompanying text.

1007

firms who are also members of OCC clear and finance the accounts of
132 options marketmakers, some of whom are specialists. In fact, the
largest NYSE stock specialist presently clears the options transactions
for 88 options marketmakers. 452/

C. Conclusions

1. The Predominant Position of the New York Stock Exchange
In 1977, NYSE attracted more than 85 per cent of the consolidated
share volume for all stocks listed on NYSE. 453/ During the first half
of 1978, it captured a median of more than 85 per cent of the consolidated
share volume of stocks on which listed options were traded. 454/ In
addition, "NYSE's total revenues, pre-tax income and net worth [in 1977]
\;ere as great as or greater than the comparable amounts for all options
exchanges and the NASD combined, and were three to five times as great as
any other exchange's." 455/ NYSE also has marketmaking resources which
substantially exceed those available to the options exchanges. 456/

452/ Data supplied in response to Options Study Questionnaire. See
Chapter VII.

453/ Securities and Exchange Commission Statistical Bulletin, supra ,
n.403.

454/ Letter to Richard Weingarten from James W. Fuller, supra , n.293.

455/ CBOE Letter, supra, n.87, at 31 (footnotes omitted) (emphasis in
original).

456/ See discussion at 212-213, supra.

1008

When evaluating NYSE proposals that contemplate NYSE participation
in the multiple trading of standardized options or the integration
of trading of options and their underlying securities on the NYSE
floor or in connection with NYSE stock marketmaking, the predominant
position of NYSE in the stock markets should be considered. To the
extent that an NYSE options market, capitalizing on NYSE's financial,
marketmaking, facilities, and other resources, as well as NYSE's primary
stock market designation and public image as the nation's premier
securities market, may attract options order flow and marketmaking
talent from the other options exchanges, it may (i) enhance the market
fragmentation concerns associated with the multiple trading of standardized
options, 457/ (ii) seriously jeopardize the financial viability of the
secondary stock exchanges and their ability to participate in the imple-
mentation of the Commission's recently announced national market system
initiatives, 458/ and (iii) eventually extend NYSE's dominance of the
securities markets to options trading and "overwhelm weaker competitors
in that market." 459/ Similarly, market information and competitive
advantages, opportunities to engage in manipulative and other improper
trading practices, potential conflicts in marketmaking obligations,

457/ See discussion at 71-86, supra.

458/ See discussion at 86-92, supra.

459/ CBOE Letter, supra, n.87, at 38. See also n.478 and. 479,
and accompanying text, infra.

1009

and market surveillance difficulties may be most significant if the
integration of stock and options trading is permitted on NYSE because
NYSE captures such a large percentage of the volume in underlying
securities and uses a unitary specialist stock marketmaking system. 460/
NYSE's predominance in the stock markets, however, is not the only
factor that should be considered when evaluating an NYSE oroposal to
initiate options trading or to integrate the trading of options and
their underlying securities. Most significantly, it should be kept
in mind that the 1975 Amendments embodied a clear legislative mandate
encouraging comoetition among market centers and marketmakers 461/
and charged the Commission with the primary responsibility "to remove
burdens on competition which would unjustifiably hinder the market's
natural economic evolution" 462/ and "to refrain from imposing * * *
any new regulatory burden on competition 'not necessary or appropriate
in furtherance of the Durposes' of the Exchange Act." 463/ In addition,

460/ See discussion at 125-138, supra.

461/ See discussion at 8-12, 65-67, supra, and Section HA(a)(l) of the
Exchange Act [15 U.S.C. 78k-l(a) (1)] .

462/ Senate Report, supra, n.17, at 12. See also Conference Report,
supra, n.i8, at ^ '-95 and House Report, supra, n.21, at 49-51.

463/ Conference Report, supra, n.18, at 94,

1010

Congress sought to assure "economically efficient execution of securities

transactions" and "the practicability of brokers executing investors'

orders in the best market." 464/

Accordingly, the potential that an NYSE options program or integration

proposal may hold for increasing competition among options exchanges and

among options marketmakers and for generally improving the quality of

the markets for options and their underlying securities should be given

serious consideration. NYSE, for instance, maintains:

[I]nstead of focusing on how NYSE entry into the
options markets might be prevented or minimized,
it is much more relevant to examine why the NYSE
should be permitted to compete fairly and equally —
and without the burden of anticompetitive restrictions
which would apply to it alone.

One crucial consideration is that some portion of
the significant aggregate capital resources and
pool of market-making and other professional talent
now represented on the NYSE trading floor could be
made available to help assure that an NYSE options
market would be characterized by the highest standards
of depth, liquidity and price continuity, and the most
effective and efficient execution of the investing
public's options orders.

A second consideration is that brokerage firm customers
would benefit from the substantial efficiencies that
would result from a firm's ability to route customers'
combined stock/option orders to a single market center
that maintains high-quality markets for both types
of securities. From the public investors' standpoint,

464/ Section HA(a)(l) of the Exchange Act [15 U.S.C. 7.8k-l(a) (1)]

1011

brokers would be able to handle stock/option contingency
orders — i.e., where execution of the options portion
of the order is contingent uoon the broker's ability to
execute the stock portion, or vice versa — more easily
and efficiently, with less chance of error, * * *.

[A third consideration is that] if concurrent trading
were permitted, specialists * * * and other market
makers would be able to use options to hedge stock
positions acquired in fulfilling their obligations
to the marketplace in the underlying stock. * * *
Allowing specialists to use options to hedge stock
positions would increase their ability and willingness
to commit capital to marketmaking in the underlying stocks.
Thus, the end result would be to improve specialist per-
formance and enhance the depth and liquidity of NYSE
markets in listed securities. Similar market benefits
could be exoected to accrue from the ability of competitive
traders and registered competitive market-makers to
engage in options trading.

Another important factor as to why the NYSE should be
permitted to trade options is the NYSE's experience
in developing trading mechanisms designed to maximize
the efficient use of available resources. * * *
[T] he NYSE has begun developing an improved options
routing capability and an automated "book" that,
hopefullv, would be ready for implementation con-
currently with the start-up of the NYSE options
program. The NYSE is also looking into other
possible computer-supported services which .might
be introduced to enhance the effectiveness -erf an
NYSE options market at some time after it has gained
essential experience in trading standardized options. 465/

465/ Id., at 9-10.

1012

As a practical matter, as the national market system for stocks

evolves, NYSE's predominant position in the stock markets may not

continue, or may continue only to a lesser degree. 466/ As NYSE has

stated :

In the rapidly changing environment of the emerging
national market system for stocks — an environment
that encourages free and open competition among
market centers and among their market-makers —
there obviously can be no assurance that the historic
predominance of the NYSE will continue. In fact, the
NYSE's share of the market for listed stocks will be
continually and increasingly vulnerable to any competing
market center that can achieve higher standards of
market-making performance. In terms of the present
inquiry, the NYSE will retain its present share of the
market for listed stocks — including those which
underlie standardized options — only to the extent
that it continues to provide the best markets and
deserves to retain that share. 467/

Furthermore, while NYSE has financial resources that are considerably

greater than those of the options exchanges, it also has considerably

greater expenses and financial commitments. Consequently, it may not

be able to use these resources, or may only be able to use a portion of

them, to gain a competitive advantage in a multiple exchange option

466/ See NYSE Letter, supra, n.85, at 12.
467/ Id., at 13.

1013

trading environment. In this regard, NYSE has noted "a number of extremely

relevant cons iderat ions : "

First, the NYSE's primary "product" is, always has been,
and will. continue to be, listed stocks. * * * [Accordingly,]
1977 NYSE expenditures relating to the principal function
of maintaining the primary marketplace for listed stocks
(and the NYSE market for listed bonds) — not options —
absorbed almost 90% of total revenues. Thus, while the
NYSE's financial position will indeed be an important
factor in its ability to risk entering competition in
options, and in providing the type of options trading
environment that will be most beneficial to public
investors, that position does not translate into any-
thing resembling the competitive advantage [that might
be] implied * * *.

Second, * * * the NYSE has made a substantial commitment
of funds and other resources to the ongoing development
of a national market system for stocks. Added to this
is the possibility that the NYSE Board of Directors may
be asked to authorize a further commitment * * *
of some $9.5 million for modernization of NYSE stock
trading facilities. All of these innovations have
the same goal: To provide order-routing and operational
efficiencies that will reduce costs to NYSE member
organizations while enabling them to improve service to
public customers. At the same time, it must be noted
that the supply of funds for these purposes and,
prospectively, for development and maintenance of an
NYSE options market, is not * * * unlimited.

Third, options are fast becoming the most important
potential revenue-producing product at many of the
other exchanges — and, in the case of the CBOE, of
course, options are the only current product. Thus,
it is reasonable to expect that other exchanges will
continue to allocate substantial portions of their
available assets and revenues to operate and improve
their individual options trading facilities and
capabilities. If NYSE entry into the options
business further stimulates such constructive efforts —
as may be anticipated — then the resulting alterations

1014

in the "form and substance of competition" in options
trading * * * will unquestionably improve the quality
of options market-making facilities and services
available to the investing public. 468/

2. The New York Stock Exchange and the Statutory Pi lemma

The 1975 Amendments directed the Commission to "facilitate the

establishment of a national market system for securities * * * in

accordance with the findings and to carry out the objective set forth

in paragraph (1) of [Section HA(a) of the Exchange Act]." 469/ Section

HA(a)(l) states the Congressional findings that, among other things,

(C) It is in the public interest and
appropriate for the protection of investors
and the maintenance of fair and orderly
markets to assure —

(i) economically efficient execution
of securities transactions;

(ii) fair competition among brokers and dealers,
[and] among exchange markets, * * * [and]

(iii) the availability to brokers, dealers, and
investors of information with respect to quotations
for and transactions in securities;

(iv) the practicability of brokers executing
investors' orders in the best market * * *. 470/

468/ Id., at 14-15.

469/ Section llA(a)(2) of the Exchange Act [15 U.S.C. 78k-l(a) (2)] .

470/ Id.

1015

One objective of a national market system is to centralize all buying
and selling interest for securities included in the system and to
encourage all dealers to make simultaneous markets within the national
structure. 471/ The system is to "evolve through the interplay of
competitive forces as unnecessary regulatory restrictions are removed" 472/
and the Carmission is "to remove burdens on competition which would
unjustifiably hinder the market's natural economic evolution and to
assure that there is a fair field of competition consistent with investor
protection in situations in which natural competitive forces cannot,
for whatever reason, be relied upon * * *. 473/ The Commission is
also to refrain from imposing burdens on competition that are not
necessary or appropriate in furtherance of the purposes of the Exchange
Act 474/ and to consider whether exchange rule proposals are consistent
with the development of a national market system. 475/

Within this statutory context, an NYSE proposal to establish an
options trading program may require the Commission to choose among these

471/ See discussion at 8-12, supra.

472/ Conference Report, supra, n.18, at 92.

473/ Senate Report, supra , n.17, at 12. See also House Report, supra ,
n.21, at 44.

474/ Conference Report, supra, n.18, at 94. See also Sections 6(b)(8),
19(b), 19(c), and 23(a)(2) of the Exchange Act [15 U.S.C. 78f(b)
(8), 3(b), s(c), and n(a)(2)].

475/ See, e.g., Sections 6(b)(5) and 19(b) of the Exchange Act [15 U.S.C.
78f(b)(5) and s(b)].

1016

competing statutory considerations. The Commission, for example, might
choose to preclude NYSE from engaging in options trading under existing
circumstances because, among other possible considerations, (i) NYSE's
predominant position in the stock markets may gradually be extended
to the options markets and result in a diminishing of competition
among exchanges and marketmakers in the options markets, (ii) the
multiple trading of standardized options involving NYSE may contribute
to further fragmentation of the options markets, (iii) competition
among options exchanges and options marketmakers involving NYSE may
not be fair due to (a) NYSE's financial and marketmaking resources
and primary market designation and order flow in securities underlying
NYSE listed options and (b) the absence of market linkages and neutral
order routing techniques in the options markets, 476/ and (iv) the
loss of options order flow to an NYSE options market may threaten
the financial well-being of secondary stock exchanges that permit
the trading of standardized options and thus the evolution of a national
stock market system composed of competing market centers. 477/ Such
a decision, however, should be considered in light of the Congressional
intent that a national market system "evolve through the interplay of
competitive forces" and that the Commission remove burdens on competition,
Similarly, the Commission should consider (i) whether, if NYSE is
not allowed to engage in options trading, competition among options

476/ See discussion at 71-86, supra , and 257-268, infra.
477/ See discussion at 86-92, supra.

1017

markets and options marketmakers may be reduced or limited; (ii) whether
execution efficiencies that NYSE may be able to introduce would be
lost; and (iii) whether it would become more difficult for brokers
to execute customer orders "in the best market."

On the other hand, the Commission, seeking to eahance competition
among options exchanges and marketmakers, to improve the quality of the
markets for options and their underlying securities, and to allow
market forces to determine the form of a national market system, may
decide to permit NYSE to implement an options program. Under existing
circumstances, such a decision may enable NYSE to strengthen its pre-
dominant position in the stock markets and to assume a similar position
in the options markets. As AMEX has stated:

Since the number of equity securities suitable for
options trading is limited and options on most of
these stocks are already listed and traded on one or
more options exchanges, NYSE will have to establish its
program principally through dual trading. Unquestionably,
this would draw options order flow away from present markets.
The combination of NYSE's dominant status in the
securities markets generally, its unique position as the
primary market in practically all equities suitable for
options trading, and the unfair advantages gained from
operating an integrated market would very likely establish
it quickly as the dominant factor in options as well.
The resulting decline in options business flowing to
existing markets, their probable loss of market making
personnel and capital, and the further strengthening
of NYSE's supremacy would result in a major and
disruptive restructuring of the securities markets.
The viability of options markets on many of the
existing exchanges trading options would be seriously
threatened. The Amex would be particularly vulnerable
because the member firm community has demonstrated that it
will not support two exchange markets for a single
security in the same geographical location.

1018

Several exchanges already facing substantial
financial pressure may find the loss of their options
market too large a burden to bear, and be forced
either to further reduce their activities or else
close entirely. In any event, the result will be a
further entrenchment of the NYSE's dominant position
in equities, the likelihood of its extending that
dominance to options, and a significant weakening
of the existing market centers, which at present
provide a highly competitive environment for options
trading and a degree of competition with the NYSE
in equities as well. 478/

Thus, enhanced competition among options exchanges and among options
marketmakers on various exchanges in the short term may result in (i)
diminished competition among options exchange and ootions market-
makers and (ii) diminished competition among stock exchanges and
stock marketmakers in the longer term. In this regard, CBOE has stated:

Superficially, it might be argued that the NYSE's
entry into options trading would enhance, rather than
decrease, competition. In purely numerical terms this
might be true; the immediate effect of the NYSE's
entry into options would be to increase the number of
competing exchanges from five to six. But in the
absence of multiple trading, there would be no increase
in direct competition. If and when expansion of multiple
trading is permitted, the NYSE would be in a position
to compete head-to-head with one or more much smaller
and poorer exchanges lacking the benefits of monopoly
power, and that competition is likely to be short-lived
at best. The inevitable tendency of the NYSE's entry
would be to decrease the possibilities of meaningful
competition among the existing options exchanges. 479/

478/ AMEX Letter, supra, n.90, at 5-6.
479/ CBOE Letter, supra, n.87, at 42-43.

1019

This longer term 'deterioration of competition" 480/ might be deemed an
unnecessary and inaporopr iate burden on competition 481/ and may impair,

480/ Id., at 43. •

481/ It should be noted that principles of antitrust law may be useful
guides to the Commission in deliberations concerning whether NYSE
entry into standardized options trading should be deemed anti-
competitive. Section 2 of the Sherman Act [15 U.S.C. 2], for
example, provides that it is unlawful for an entity which dominates
one market to use that dominance to affect adversely its competitors
in another market. See, e.g. , United States v. Aluminum Co. of
America, 148 F.2d 416 (C.A.2, 1945); United States v. Griffith,
334 U.S. 100 (1948). Section 7 of the Clayton Act also provides
tht "no corporation enqaged in commerce shall acquire * * * any
part of the stock * * * of another corporation * * * where in any
line of commerce in any section of the country, the effect of such
acquisition may be substantially to lessen competition, or tend
to create a monopoly," 15 U.S.C. 18. Accordingly, it may be
unlawful for a new entrant to a market to threaten, by means of a
combination, to entrench an existing market participant by giving
it the means to dominate the market. See, e.g., FTC v. Proctor
& Gamble Co., 386 U.S. 568 (1967); AllisK:halmers v. White Consolidated
Industries, Inc., 414 F.2d 506 (C.A.3, 1969); United States v. Wilson
Sporting Goods Co., 288 F.Supp., 543 (N.D. 111., 1968). Further,
mergers extending a firm's product line that may eliminate the
acquiring firm's competitors may violate Section 7 of the Clayton
Act. See, e^g., Proctor & Gamble, supra, ; Kennecott Copper Corp.
v. FTC, 467 F.2d 67 (C.A. 10, 1972); Bendix Corp. [1970-1973
Transfer Binder] Trade Reg. Rep. 11 19,288 (FTC, 1970). Mergers
creating the probability of reciprocal dealing may also run afoul
of Section 7. See, e^g., FTC v. Consolidated Foods Corp., 380
U.S. 592 (1965).

Because self -regulatory organization rulemaking proposals are to a
large extent immunized from the application of the antitrust laws,
the principles of these antitrust cases should be viewed as
analytical tools rather than as binding precedent. See Gordon v.
New York Stock Exchange, 422 U.S. 659 (1975) and United States v.

(footnote continued on next page)

1020

depending on the extent of the deterioration, the Commiss ion's ability
to facilitate a national market system for stock or options by reducing
the number, resources and capacity of the stock and options market
centers and marketmakers to.be included in such a system. Moreover,
competition among the other options exchanges and NYSE and among options
marketmakers on other options exchange and NYSE options marketmakers might
be considered unfair under present conditions due to (i) the competitive
advantages that NYSE options marketmakers may derive from their pre-
ferential access to NYSE's stock market for informational and execution
purposes, NYSE's financial and marketmaking resources, and NYSE's order
flow and designation as the primary market for underlying stocks, (ii) the
absence of communications linkages tying the options markets together
and providing options marketmakers on all options exchanges with the
opportunity to interact with the order flow for multiply traded classes

(footnote continued)

National Association of Securities Dealers, Inc., 422 U.S. 694 (1975).
See also CBOE Letter, supra, n.87, at 42-44; AMEX Letter, supra,
n.90, at 66-72; PHLX Letter, supra, n.88, at 10-12; NYSE Letter,
supra, n.85, at 16-17; and Letter to George A. Fitzsimmons,
Secretary, Securities and Exchange Commission, from James E. Buck,
Secretary, NYSE, dated November 29, 1978. A copy of this letter
follows the NYSE Letter in Appendix Exhibit 1.

1021

on all exchanges, 482/ and (iii) brokerage firm option order routing
practices involving a primary market designation. 483/

3. A Cautious Approach

Should the Commission determine to resolve the statutory dilemma by
permitting NYSE to establish an options market, a cautious approach to
the initiation of NYSE options trading may alleviate some of the regulatory
concerns that such trading may create. Two approaches may be followed. 484/

First, the Commission may take steps to assure that NYSE would
begin options trading under circumstances as nearly equal to those
prevailing on other exchanges as is practicable. Such steps should
be designed to minimize competitive advantages that NYSE may enjoy
as a result of its predominant position in the securities markets
generally and in underlying securities particularly. For example, when
reviewing an NYSE proposal to initiate options trading, the Commission
may seek to assure that:

482/ See discussion at 71-74, supra , and 266-268, infra.

483/ See discussion at 52-61, 75-86, supra.

484/ The Commission, of course, would have to approve any NYSE proposal
to initiate standardized options trading pursuant to Section 19(b)
of the Exchange Act [15 U.S.C. 78s(b)] before such a program could
become operational. Notice of the proposed rule change and an
opportunity for public comment would also be provided in accordance
with that section. During such a proceeding, it may be feasible
to explore the viability and ramifications of the alternative
approaches set forth above with greater specificity.

40-940 O - 79 - 67

1022

1. NYSE stock and options trading floors would be
distinct and completely separated by physical barriers; 485/

2. NYSE stock specialist and registered stock market-
makers would not be permitted to trade options on their
specialty stocks or stocks in which they hold a position
except perhaps for the purpose of hedging their stock
positions in accordance with a definition of hedging that
the Commission has approved; 486/

3. NYSE stock specialists and registered stock market-
makers would not have access to the options trading floor,
and NYSE options marketmakers would not have access to the
NYSE stock trading floor under any circumstances. NYSE
stock specialists and registered marketmakers who enter
option orders and option marketmakers who enter stock orders
would be required to enter such orders in the same manner

as other market participants who do not have direct access
to the NYSE floor; 487/

4. Quotation and transaction information concerning
stock and options trading activity would be transmitted
between the NYSE stock and options floors only in the same
manner that it is currently disseminated between NYSE and
the options exchanges; and

485/ While NYSE does not contemplate side-by-side trading or dual
marketmaking at this time, the NYSE Plan clearly expected that
option classes would be traded on the main equity floor. See
NYSE Letter, supra, n.35, at 1, 19 and discussion at 207, 225-227,
supra. See also, e.g. , Securities Exchange Act Release No. 11423,
supra , n.74.

486/ See discussion at 144-148, supra.

487/ The NYSE Plan did not contain restrictions on the ability of stock
and options marketmakers to pass from one trading floor to the
other. See discussion at 207, supra .

1023

5. The NYSE options program would be maintained
as a separate cost center such that stock revenues and
income could not be utilized to subsidize options
operations. 488/

Second, NYSE might be permitted to implement an options trading

program only at such time as a national market system for options, or

certain aspects of such a system are, or are nearly, operational. CBOE,

for example, has urged that "further expansion of multiple trading

should not be permitted unless and until a national market system

or subsystem for options, and the resulting fair field of market

competition, have been substantially achieved." 489/ While CBOE

admits that "putting off the expansion of multiple trading in options

[and thus, NYSE entry into the options markets] until [they] can occur

in the context of a national market system suitable for options trading

may mean a considerable delay," it also believes that the problems of

"not waiting until basic facilities of such a system are operational

appear far worse." 490/

488/ NYSE has already stated that its "proposed options market" would
be run "as a separate cost center." NYSE Letter, supra, n.85,
at 19. =

489/ CBOE Letter, supra, n.87, at 10.

490/ Id. , at 16. Summarizing these problems, CBOE has stated:

In the absence of a national market system for
options, we believe it is clear that multiple trading
has had, and if expanded would increasingly have,

(footnote continued on next page)

1024

NYSE, on the other hand, has stated:

[T]he NYSE believes there is no reason why the expansion
of dual trading of standardized options should be delayed
oending further development of a national market system
for either stocks or options, or both.

[T]he Commission has indicated that it expects the national
market system to develop in an evolutionary manner, rather
than to be established at a predetermined point in time.
The NYSE believes this is the correct — indeed, the only
possible — approach to a national market system.

The NYSE believes, further, that the public benefits
and advantages generally perceived as flowing from a
national market system for stocks should be extended
to options trading. But whether that objective might
be achieved by integrating options trading into a national
market system for stocks or by developing a separate
national market system for options — or by some other
means — is * * * presently unclear .

(footnote continued)

a number of undesirable effects: (1) Multiple trading
creates undesirable fragmentation and, at times,
disorderliness and confusion in the options markets.
(2) MultiDle trading confronts brokerage firms doing a
public business with very difficult practical and
legal problems of 'best execution"; these tend to be
resolved by the selection of one market as the "primary
market" for any given class of options, with a consequent
decline in true competition as between that market and
all other markets. (3) There does not exist today a fair
field of competition among markets, so that multiple
trading in the existing circumstances would lead to a
long-term decline in competition.

Id., at 10.

1025

What is clear is that public investors should obtain,
without unnecessary delay, the benefits and advantages
that will result from expanded industry-wide dual
trading of standardized options — including dual
trading in an NYSE options market. It is also clear
that substantial industry-wide experience with a dual-
trading environment must be a prerequisite for meaning-
ful industry-wide participation in decision-making
relevant to any future environment that such experience
may show to be appropriate for options trading.

Thus it would be distinctly counterproductive to delay
expansion of dual trading of standardized options or
to Drevent the NYSE from participating in dual trading,
since any such decision would keep the industry from
gaining the knowledge and experience needed to help
determine what, if any, national market system-type
mechanisms or elements might ultimately best serve
the interests of public investors in options. 491/

In sum, deferring NYSE entry into the options markets until elements

of a national options market system are in place 492/ and the evolution

of a national market system for equity securities is further along may

go a long way toward (i) minimizing the effects that NYSE's predominant

oosition in the markets for underlying securities may have upon NYSE's

ability to become predominant in the options markets, (ii) assuring

that competition among options exchanges and options marketmakers occurs

within the fairest regulatory field obtainable under the circumstances,

and (iii) improving the likelihood that a national stock market system

491/ NYSE Letter, supra , n.85, at 17-18 (footnote omitted)
492/ See discussion at 71-86, suDra, and 257-272, infra.

1026

with comoeting market centers will evolve successfully. At the same time,
such an approach may be deemed inconsistent with the Congressional mandates
that a national market system "evolve through the inter Dlay of competitive
forces " 493/ and that the Commission refrain from imposing unnecessary or
inappropriate burdens on competition. 494/ On the other hand, it should be
kept in mind that the 1975 Amendments were designed to provide "maximum
flexibility to the Commission * * * in giving specific content to the
general concept of the national market system," 495/ and that the Commission
is not required to justify its actions as "the least anti-competitive
manner of reaching a regulatory objective." 496/

When considering either of these approaches to an NYSE options
trading proposal, two additional factors should be taken into account.
First, it may be inconsistent with the purposes of the Exchange Act
for the Commission '"to attempt to orotect any market center's share of
the market for any security." 497/ As NYSE has observed:

493/ Conference Report, supra, n.18, at 92.

494/ Id., at 94.

495/ Id., at 92.

496/ Senate Report, supra, n.17, at 13-14. See also discussion at 12-14,
supra.

497/ NYSE Letter, supra, n.85, at 19. See also Securities Exchange

Act Release No. 11942, supra , n.210, at 35 and 40, and discussion at
92, supra .

1027

Clearly, the market center or market-maker that
provides the "best" market in a given security
should be exrjected to attract an approDriate
share of the order flow in that security. The
well-recognized principles which underlie a
broker's obligations to his customer demand that
result. In adooting the 1975 Amendments, Congress
surely endorsed this cardinal princiole of
competition. And there is no indication anywhere
that Congress, in specifically calling upon the
Commission to use its authority under the Act
to ensure enhancement of competition throughout
the securities industry, intended that the
Commission would seek out opportunities to suppress
fair and open comoetition under the presumption
that one or another market center might lose
business if such fair and open competition
were permitted to flourish. 498/

In addition, the Exchange Act requires that competition among exchange

markets and among marketmakers be "fair." 499/ Clearly, "a dominant firm in

one market may not extend its dominance to another market by anticompetitive

means." 500/ Accordingly, the Commission should carefully monitor the

form and substance of competition among market centers and among

marketmakers if an NYSE options plan is approved. In particular, the

Commission should discourage the use of NYSE regulatory authority and

"intangible resources1' to attract options order flow. Further, it may

be considered "unfair" to oermit .MYSE stock socialists and marketmakers

498/ Id.

499/ See, e.g., Section HA(a)(l) of the Exchange Act [15 U.S.C.
78k-l(a)(l)].

500/ Letter to George A. Fitzsimmons from James E. Buck, supra, n.481.

1028

to subsidize NYSE options marketmaking activities with revenues derived
from their stock trading. Similarly, discounting stock brokerage
rates or engaging in reciprocal dealings for the purpose of attracting
options order flow may be considered unfair, anticompetitive practices.
While it may be difficult for the Commission to regulate these areas
directly, individual instances in which unfair competitive practices
are discovered should be sanctioned severely.

VIII. A NATIONAL MARKET SYSTEM FOR STANDARDIZED OPTIONS

A. Options and the Evolving National Market System

Section HA(a)(2) of the Exchange Act provides:

The Commission by rule, shall designate the securities
or classes of securities qualified for trading in the
national market system from among securities other
than exempted securities. (Securities or classes of
securities so designated hereinafter in this section
referred to as "qualified securities".) 501/

The Exchange Act also directs the Commission "to facilitate the establishment

of a national market system for securities (which may include subsystems

for particular types of securities with unique trading characteristics)." 502/

501/ Section HA(a)(2) of the Exchange Act [15 U.S.C. 78k-l(a)(2;
502/ Id.

1029

While the Congress intended that a national market system encompass "all
segments of the corporate securities markets including all types of common
and preferred stocks * * * and options," 503/ it also recognized that securities
with "unique characteristics" 504/ may require different "treatment" 505/
and gave the Commission "broad, discretionary powers" 506/ and "maximum
flexibility" 507/ to establish "subsystems within the national market system
which are tailored to the characteristics of the particular types of
securities which are to be traded in each subsystem." 508/

The Commission has not yet designated the securities that will be
"qualified" for trading in a national market system. 509/ The Commission
has, however, stated its belief that "listed equity securities included
in the consolidated [transaction reporting] system and a number of equity
securities traded exclusively in the over-the-counter market generally
possess characteristics * * * which justify their inclusion in the

503/ Senate Report, supra, n.17, at 7. See also Conference Report,
supra, n.18, at 92.

504/ Conference Report, supra, n.18, at 92.

505/ Id., at 93.

506/ Senate Report, supra, n.17, at 7.

507/ Conference Report, supra , n.18, at 92.

508/ Id., at 93.

509/ January Release, supra , n.176, at 43.

1030

'qualified' category." 510/ Accordingly, although Congress contemplated
that a national market system would include standardized options, the
Commission has not begun to consider whether standardized options are appropriate
for inclusion as qualified securities or whether it would be more appropriate
to design a "subsystem" of a national market system to comprehend standard-
ized options trading. In fact, when issuing the January Release, the
Commission specifically stated that it was "not yet prepared to determine
what role standardized put and call option contracts should play in a
national market system or the appropriate relationship which should exist
between trading in equity securities underlying such options and trading
in the options themselves." 511/

B. Cptions and the Objectives of a National Market System

The objectives of a national market system are far from being
realized in the options markets. Buying and selling interests for
multiply traded options classes, for example, are not centralized "so
that each investor will have the opportunity for the best possible
execution of his order, regardless of where in the system it originates." 512/

510/ Id.

511/ Id., at 44.

512/ Senate Report, supra, n.17, at 7. See also House Report, supra,
n.21, at 50-51. See discussion at 50-52, 61-65, supra.

1031

In addition, the orotections and benefits of the auction market [for
multiply traded ootions classes] * * * remain limited," 513/ and "the
linkinq of all [ootions] markets * * * through communication and data
processing facilities [to] foster efficiency, enhance competition,
increase the information available to brokers, dealers, and investors,
facilitate the offsetting of investors' orders, and contribute to best
execution of such orders" has not been accomplished. 514/ Moreover,

513/ Senate Reoort, supra , n.17, at 17. The example that the Senate
Report provided concerning the limitations of auction trading
principles in the stock markets is equally applicable in the
options markets under present conditions:

[A] limited price order is presently "protected" as to
price priority on the exchange on which it is held
but it is not protected in any way [with] respect to
trading on another exchange or in the third market.
As a consequence, a limit order for a listed security
held in only one of several markets for that se-
curity need not be executed before a transaction
is effected at the same price or at a price less
favorable to the other party in another market.
In the Committee's view this is the basic problem
caused by the fragmentation of the securities
markets: the lack of a mechanism by which all
buying and selling interest in a given security
can be centralized and thus assure public investors
best execution.

Id., at 16-17. See discussion at 61-65, supra.

514/ Section llA(a)(l)(D) of the Exchange Act [15 U.S.C. 78k-l(a) (1) (D)]
It should be kept in mind that Congress viewed the linkage of
competing market centers and marketmakers as the most appropriate
means of achieving a national market system and assuring the
practicability of executing investor orders in the best. market.
See, e.g., discussion at 71-72, supra.

1032

competition 'among exchange markets and between exchange markets and
markets other than exchange markets" 515/ does not exist for option
classes traded on only one options exchange, 516/ and competition "among
brokers and dealers" 517/ in these classes is limited to that which can
be obtained on the floor of the listing exchange. 518/ On the other
hand, competition among the options exchanges and among options market-
makers may not be "fair" 519/ and "the practicability of brokers executing
investors' orders in the best market" 520/ may not be assured at present
with respect to multiply traded option classes. 521/

515/ Section llA(a)(l)(C) of the Exchange Act [15 U.S.C. 78k-l(a) (1)(C)] .

516/ In this regard, the Congressional view that multiple trading

is "appropriate to a national market system in which all market
makers and brokers are permitted to deal freely with one another
without unnecessary regulatory restraints" should be noted.
Senate Report, supra, n.17, at 20.

517/ Section llA(a)(l)(C) of the Exchange Act [15 U.S.C. 78k-l(a) (1) (C)] .

518/ In this connection, the Congressional goal of giving "encouragement * * *
to all dealers to make simultaneous markets within the new national
[market] system" should be kept in mind. Senate Report, supra, n.17,
at 14.

519/ Section HA(a)(l)(C) of the Exchange Act [15 U.S.C. 78k-l(a) (l)(d)] .

520/ Id.

521/ As CBOE has stated:

[I]t is often impracticable for brokers to achieve
best execution [for multiply traded classes] in the
present circumstances. Since it is not now possible

(footnote continued on next page)

1033

Since the objectives of a national market system have yet to be

achieved with respect to standardized options trading, the Commission

should solicit Dublic comments, and perhaos set forth its views,

concerning (i) the appropriate relationship between the evolution

of a national market system for equity securities and the evolution

of a national market system which would include standardized options

and (ii) the steps that should be taken to establish a national market

system which would include standardized options. More specifically,

the Commission should seek public comments, and, if appropriate, express

its views, regarding:

1. Whether standardized options should be included as
"qualified1' securities to be integrated into a national market
system for stocks, or whether a "subsystem" of a national market
system should be created for standardized options trading;

(footnote continued)

for brokerage firms to direct each order to the "best"
market at a particular instant, there has been a
tendency for the great bulk of the public orders
handled by a particular firm to be transmitted
automatically to a designated exchange, as being the
"primary market," whether or not the prices or
quotations on that exchange are the best prevailing
at any given time.

CBOE Letter, suora, n.87, at 12-13 (footnotes omitted).
See also discussion at 52-61, and 75-86, supra.

In this regard, the Congressional mandate that brokerage firm
order routing systems be "neutral" in nature and give "preference
to one execution facility over another only to insure best
execution" should be kept in mind. See discussion at 15-17,
and 77-80, supra, and 266-268, infra.

1034

2. Whether national market system initiatives such as
those recently undertaken in connection with a national market
system for stocks would be appropriate with respect to
standardized options; and

3. An orderly procedure for designing and implementing

a national market system which would include standardized options.

When beginning to formulate views concerning the first steps that
might be taken to facilitate the establishment of a national market
system which would comprehend standardized options trading,
three points discussed previously in this chapter should be
noted. First, the development of market linkages providing for (i)
coordinated openings for multiply traded option classes, and (ii)
a prompt and efficient means of sending buy and sell orders among the
options exchanges may do much to reduce the effects of fragmentation
on the markets for multiply traded options. 522/ Further, the develop-
ment of order routing techniques which would (i) consider the size
of public orders in relation to current quotations in the markets that
permit the trading of an option class so that small orders can routinely
be sent to the market offering the best quotation, (ii) permit the
immediate rerouting of orders from one market to another in the event
that a market encounters operational or other difficulties that may
prevent the prompt and efficient execution of public orders at the best
available prices, and (iii) permit customers and registered representatives
to route orders when one market is clearly better than another may go a

522/ See discussion at 71-74, supra, and 266-268, infra.

1035

long way toward assuring "the practicability of brokers executing investors'
orders in the best market" and that competition among options marketmakers
and among the options exchanges is "fair." 523/ Finally, to the extent
that market linkages, enhanced order routing systems, and other such
national market facilities are in place, any expansion of the multiple
trading of standardized options that is permitted may occur under
circumstances more in accordance with those that the Exchange Act
envisions than those that prevail at this time. 524/

C. The Form of a National Market System

A national market system which would include standardized options trading
could take a wide variety of forms. It would, of course, be premature to
attempt to describe an appropriate form at this juncture, particularly without
the benefit of public and Commmission views concerning many of the issues
discussed in this chapter. While the "development of a national market
system should remain essentially an evolutionary process, free of the
rigidities inherent in any Commission attempt to dictate the ultimate

523/ Section llA(a)(l)(C) of the Exchange Act [15 U.S.C. 78k-l(a) (1) (C) ] .
524/ See discussion at 71-86, 245-250, n.387, supra.

1036

configuration of that system," 525/ brief consideration of four points may
provide some perspective on national market system questions relating
to standardized options.

1 . A Comprehensive Quotation System

Section HA(a)(l) of the Exchange Act provides:

(C) It is in the public interest and appropriate for
the protection of investors and the maintenance of fair
and orderly markets to assure

(iii) the availability to brokers, dealers,
and investors of information with respect to
quotations for and transactions in securities
* * *. 526/

In this regard, the Commission has stated:

The Commission believes that the availability of com-
prehensive quotation information, a fundamental
building block of the national market system, will
improve both brokers' and public investors'
knowledge of current prices at which reported
securities can be bought or sold throughout the
country. In turn, availability of this information
should (i) lead to increased efforts by brokers
to make informed order routing decisions from
among the various competing market centers (in
order to choose that particular market affording
at a particular point in time, the most favorable

525/ January Release, supra, n.176, at 38.
526/ 15 U.S.C. 78k-l(a)(l)(C).

1037

execution opportunities to their customers);
(ii) foster improvements in existing methods of
routing orders to all market centers; (iii)
enhance fair competition among markets; and
(iv) otherwise advance the objectives of a
national market system specified by the Congress
in Section HA(a) of the Act. 527/

Accordingly, the Commission adopted Rule llAcl-1 528/ to facilitate the prompt
development of a composite quotation system for "equity securities as
to which last sale information is reported in the consolidated trans-
action reportinq system * * * contemplated by Rule 17a-15 529/ under the
Act * * *." 530/ Subject to certain exceptions, Rule llAcl-1 provides:

[E]very responsible broker or dealer shall be obligated
to execute any order to buy or sell a reported security,
other than an odd-lot order, presented to him by
another broker or dealer , or any other person belonging
to a category of persons with whom such responsible
broker or dealer customarily deals, at a price at
least as favorable to such buyer or seller as the
bid price or offer price comprising such responsible
broker's or dealer's published bid or published offer * * *
in any amount up to his published quotation size. 531/

Rule llAcl-1 does not apply to options trading because options

transactions are not reported in the consolidated system contemplated

527/ January Release, supra , n.176, at 38-39.

528/ 17 C.F.R. 240.11AC1-1.

529/ 17 C.F.R. 240.17a-15.

530/ Securities Exchange Act Release No. 14415, supra, n.176, at 14.

531/ 17 C.F.R. 240.11Acl-l.

40-940 O - 79 - 68

1038

by Rule 17a-15. 532/ Nor has Rule llAcl-1 been applied to any exchange
which "currently utilizes [a competing market maker] system generally for
trading in reported securities." _533/ Although the Commission recognized
that "compliance with Rule llAcl-1 may be more difficult in a multiple
market maker exchange environment," it did not consider" modifying
Rule llAcl-1 or altering its basic approach to collection of quotation
information to take into account multiple marketmaking in reported
securities." 534/ However, the Commission also "clearly state [d] its intent
that the adoption of Rule llAcl-1 should not discourage competition among
market makers and its commitment to give further consideration" to the
problems associated with fashioning a rule such as Rule llAcl-1 under
circumstances involving "a large number of market makers on a single
exchange floor." 535/

CBOE comments in response to Rule llAcl-1 when it was proposed provide
relevant insights into the difficulties that may accompany efforts to
establish a rule comparable to Rule llAcl-1 in the options markets. These

532/ Instead, consolidated options last sale information is reported

through the system of the Options Price Reporting Authority ( "OPRA" ) ,
which system was approved by the Commission under the since withdrawn
Rule 9b-l. OPRA is a registered securities information processor
under Rule HAb2-l [17 C.F.R. 240.1lAb2-l] .

533/ Securities Exchange Act Release No. 14415, supra , n.176, at 24.

534/ Id.

535/ Id.

1039

comments are quoted at length to emphasize the nature and scope of the

problems that may be associated with any attempt to provide "comprehensive

quotation information" in the options markets:

Competing Market-Maker System. CBOE's options
market differs from the traditional stock exchange
market in that CBOE has replaced the traditional
exchange specialist who has combined brokerage and
market-making functions with (i) a single Board
Broker who holds the book of agency limit orders
and (ii) a group of competing market-makers who,
in comoetition with each other, collectively perform
the market-making function of the traditional
soecialist. There are also floor brokers on CBOE,
but here, too, the broker and dealer functions
are separated, since no CBOE member may on the same
day execute orders as agent and as principal in
options relating to the same underlying security.
This market-making system, which was first introduced
by CBOE when it began trading options in 1973, has
to a large degree served as the model for the options
orograms of other exchanges that have subsequently
begun to trade options.

Perhaps the most obvious difference between CBOE's
competing market-maker system and the unitary specialist
system is that under the former system there are many
more individual market-makers entering bids and offers
in each security. Further, since these market-makers
may not represent agency orders, and because many types
of options orders cannot be held in the Board Broker's
book, there are also a great number of brokers in each
trading crowd bidding and offering on behalf of customers.
Typical trading crowds on CBOE include 8-10 market-makers,
4-6 floor brokers, plus the Board Broker, and considerably
larger trading crowds are not uncommon. Reflecting these
large and busy trading crowds, and the great number of
Dersons entering bids and offers in each security, CBOE
has developed a unique system for collecting and
disseminating current quotations. In each crowd there
is an exchange employee whose sole task is to monitor

1040

the quotations that are made from moment to moment by
market-makers, floor brokers and the Board Brokers,
and to publish a representative bid and offer with
respect to each security traded in the crowd at any
time. During an average trading day, this system
results in approximately 20,000 separate quotations
being published for the 95 call and 5 put classes
of options traded on CBOE. Each of these quotations
represents a bona fide bid or offer entered by a
person willing to buy or sell at the quoted price,
although these quotations would not meet the firmness
requirement of the proposed rule. However, we do not
think that these quotations are any the less useful
for not being firm, since the usefulness of these
quotations is not deoendent upon how long a time
after their entry they remain good, but rather is
that they provide a "sense" of the current state of
the market that is not otherwise obtainable away
from the floor. In fact, a likely result of imposing
a firmness requirement on these kinds of quotations
would be to detract from their usefulness, since under
a firm quotation rule many quotations will not be entered
at all, reflecting the reluctance of options market-
makers to enter bids and offers into a system that
does not provide the capability of quickly adjusting
them in response to changing market conditions.

Turning to the cost side of the cost-benefit
equation, in a competing market-maker system the costs
of implementing a firm quotation system would be
enormous. In order to collect and publish current
quotations under its present system, CBOE employs
46 quotation reporters for its 100 option classes,
and this number will expand as more put classes
are added. Yet expensive as this is, it could not
begin to meet the requirements of a firm quote rule
under which each quotation, including size, would have
to be identified with the particular market-maker,
floor broker or Board Broker that was responsible for
it. In addition, under a firm quote rule there would
have to be the capability of permitting each member
who had previously submitted a quote to withdraw. or

1041

modify that quote on an immediate basis so as to
terminate his responsibility for a quote that is no
longer current. Any system that might be developed
to accomplish this would, we believe, necessarily
result in each market-maker, floor broker and Board
Broker being literally tied to his own computer terminal
Apart from the enormous financial costs of such a
system, its implementation would undoubtedly result
in radical changes in the nature of any competing
market-maker system operating under it. Reflecting
these enormous costs and other burdens, we believe
that as a practical matter it would be impossible
for an exchange to provide meaningful market-making
competition on its floor and at the same time
comply with the proposed rule.

In fact, given the number of persons that are
constantly entering quotes in CBOE's options market,
the inclusion of size information alone, apart
from any firmness requirement, gives rise to
technical difficulties almost as great as those
presented by a firm quote rule. The problem is
much like that discussed above: namely, that
without a system to identify particular quotes
with the persons making them, specific size
information is meaningless. We are studying the
possibility of including in published quotation
information under our present system some indication
of approximate size based upon the quote reporter's
sense of the number of options being bid or offered
at the published or ice, but even this raises technical
questions of capacity with respect to our equipment
and that of quote vendors.

Finally, we would point out that as a result
of the foregoing, the imposition of a firm quote
rule in respect of options would mean that those
exchanges such as CBOE that trade options under a
competing market-maker system would probably have
to abandon that system, resulting in an overall
decline in the level of competition. Even if these
exchanges could somehow adapt their competing
market-maker systems to function under a firm
quotation rule, the systems costs necessary to

1042

effectuate such an adaption would place these
exchanges at a serious competitive disadvantage
compared to those options exchanges that operate
under a unitary specialist system.

Options are Derivative Securities and are Traded
in Several Different Series. The price of an option
is largely dependent on the price of the underlying
security, and for certain "in-the-money" options this
deoendence is virtually absolute. This means that bids
or offers that may be made for an option at any time
cannot hold once the market for the underlying security
has changed. Thus, unlike stocks, in the case of options
one must monitor one's quotations not only against
transactions in the quoted security, but also against
transactions in the underlying security. And, as if
this were not enough, there is the added complicating
fact that options are traded in a number of different
series, varying as to expiration price, expiration
date or both, and here, too, price relations must be
kept in line.

In the average option class traded on CBOE, there
are 8 to 10 different series available at any time,
and in certain classes the number has been much higher ,
reflecting that additional series have been opened on
account of price movements in the underlying security
or on account of stock splits or distributions. In
those underlying securities where puts as well as
calls are available, the number of series is
double those stated above. Since options that
relate to three underlying securities are traded at
each post on the CBOE floor, each market-maker (and,
potentially, each floor broker) in the crowd must
monitor the market in 24-30 different securities at
the same time (48-60 securities where puts are traded),
and must be prepared to modify or withdraw his quotes
on account of changes in the market for any of these
securities. Plainly if the bids and offers of brokers
or dealers were firm under these circumstances, the
market could not function. And, as discussed below,
the notion that this problem could be solved through
the aoplication of a limited time grace period falls
of its own weight.

1043

Combination Orders. As previously noted, options
are often traded as spreads, straddles or other
combinations. Commonly these are bid or offered at
net prices, leavinq it to the broker or dealer to
fill the separate components of the order at what-
ever or ices net to a price as good as or better than
that stated in the order. Thus an order to "buy" a
particular spread involving the purchase of one option
and the concurrent sale of another at a net price of
3 could be filled by buying the first option at 7-1/2
and selling the other option at 4-1/2 or buying the
first at 7-3/8 and selling the second at 4-3/8. Often
a broker or dealer holding such a combination order
will enter a bid or offer for one "leg" of the
combination, provided he is able to fill the other
leg at a price that will permit the entire order to
be filled at the net price. But no broker or dealer
would enter quotes for one leg only if it meant they
were firm until withdrawn. Either such contingent
quotes would have to be excluded from the operation
of the rule, or they would just not be entered. Yet
given the importance of these kinds of orders in the
options market, their exclusion would significantly
reduce the usefulness of published quotation information
and would result in a non-published market-within-the-
market available only to certain professionals but not
to the public. 536/

Clearly, these factors should be considered in connection with any

proposals or plan to establish a composite quotation system for options that

may be included in a national market system.

536/ Letter to George A. Fitzsimmons, Secretary, Securities and Exchange
Commission, from Joseph W. Sullivan, President, CBOE, dated
August 1, 1977, at 2-6 (footnote omitted).

1044

2 . Market Linkage and Order Routing Systems

When announcing the initiatives that "the Commission considers

necessary to accelerate implementation of a national market system," 537/

the Commission stated:

The Commission intends to encourage and, if necessary,
mandate the prompt development of comprehensive market
linkage and order routing systems to permit the
efficient transmission of orders (i) among the various
markets for qualified securities, whether on an
exchange or over-the-counter * * *, and (ii) from
brokers and dealers to all qualified markets.
The Commission believes that communications and
data processing facilities which link all qualified
markets and permit orders in qualified securities to be
transmitted promptly and efficiently from brokers or
dealers to any qualified market, and from one such
market to another, are necessary to increase the
opportunities for brokers to secure best execution of
their customers' orders, to ensure effective competition
among qualified markets and to achieve the purposes of
a national market system established by the Congress
in Section llA(a) of the Act. 538/

The Commission also stated its belief that "all systems used to route

orders to and among qualified markets should operate in a 'neutral'

fashion (i.e., they should permit brokers and dealers utilizing those

systems to route orders to and among all such markets on a non-discriminatory

basis ).'■ 539/ Further, when adopting Rule HAcl-1, 540/ the Commission

stated:

537/ January Release, supra , n.176, at 32.
538/ Id., at 39.

539/ Id., at 39-40 (footnote omitted).
540/ See discussion at 258-260, supra.

1045

Although the Commission cannot predict with certainty
the effect quotation information disseminated pursuant
to the Rule will have on brokers' decisions as to which
of the several markets should be selected for execution
of their customers' orders, the Commission's expectations
are that implementation of Rule HAcl-1, and the
resultant general availability of relatively "firm"
quotations and quotation sizes for reported securities,
will have a favorable impact on brokers' order routing
decisions and upon the changing nature of brokers'
agency obligations to their customers. 541/

Market linkage and order routing systems similar to those that the

Commission has sugqested for the stock markets may be equally appropriate

for the options markets. 542/ Without the availability of options quotations

that are firm and contain size, however, such systems may not be maximally

effective. Brokers and dealers, for example, may be reluctant to send

options orders to a market displaying the highest, bid or lowest offer

if he cannot (i) identify the party or parties who have made that bid

or offer, (ii) hold that party or parties to the bid or offer, and

(iii) ascertain the number of contracts bid for or offered. On the

other hand, to establish a Quotation rule which would contemplate

options quotations that are firm, identify the market participant

making the quote, and contain the number of contracts bid for or offered

541/ Securities Exchange Act Release No. 14415, supra, n.176, at 22.
542/ See discussion at 71-86, 245-249, and n.387, supra.

1046

may be the death knell to the competing marketmaker system of options
trading on exchange floors. 543/

3. Nationwide Limit Order Protection

The Commission has stated that it "continues to believe that one of

the basic principles upon which a national market system must be based

is the assurance that all agency orders in qualified securities, regardless

of location, receive the benefits of auction-type trading protections." 544/

Accordingly, the Commission has suggested that the self-regulatory

organizations develop a "central limit order file (the 'Central File')

for public agency orders to buy and sell qualified securities in specified

amounts at specified prices * * *." 545/ As the Commission explained:

The objectives of a Central File are relatively simple:

to make available a mechanism in which public limit

orders can be entered and queued for execution in

accordance with the auction trading principles of

price and time priority and by means of which such

orders can be assured of receiving an execution prior

to the execution of any other order by a broker or

dealer in any market at the same or an inferior price * * *

Public limit orders would assume their place in,

and have an equal opportunity to achieve an execution

throughout, that system without regard to the market

or geographical location from which those orders were

entered or in which other transactions required to

543/ See discussion at 260-265, supra.
544/ January Release, supra , n.176, at 40
545/ Id. (footnote omitted).

1047

yield priority to orders in the Central File were
effected. Execution priority for orders entered
in the Central File over all other orders would be
required by rule. 546/

CBOE, however", has pointed out that there "are several characteristics

of options trading that will make the development of a composite book for

options more complex than in the case of stocks." 547/ Specifically,

CBOE stated:

a. The ootions market is a derivative market,
in the sense that prices are basically dependent on
underlying stock prices. But it is a derivative
market of a special kind because, for any given stock
or ice movement, there may be a considerably greater
need for cancellations and entries of new orders in
options than in stocks, thus putting much greater
pressures on any system for handling limit orders.

In other words, price movements in the underlying
market can produce accentuated order surges in the
option market as compared with the underlying market
itself.

b. On CBOE * * * the broker and dealer functions
of the specialist have been separated and assigned to
different categories of members — a single "board
broker" and competing "market makers" for each security
traded. In the development of any composite book for
multiple market centers within a national market system,
one of the most complex questions is whether and how to deal
with the interaction between the book and the auction
process in the separate markets. This complexity may be
greatly compounded where one or more of the market centers
has the traditional specialist system and one or more has
the CBOE system involving separation of the specialist
function. On the one hand, if the system were such that a

546/ Id. (footnotes omitted).

547/ Letter to George A. Fitzsimmons, Secretary, Securities and Exchange
Commission, from Joseph W. Sullivan, President, CBOE, dated
May 3, 1976, at 1.

1048

specialist could take advantage of his combined functions
while competing market makers of the CBOE-tyoe had no
direct access to the book, the fairness of competition
between two types of markets would be seriously affected;
but on the other hand, if the system were designed to
give each market maker direct access, a whole new set of
technological and economic problems would have to be
considered. 548/

It should be noted, however, the CBOE is Dresently developing, and
exoerimenting with, an automated limit order book and order routing system
for its options market. Among other things, the Order Support System
would (i) provide CBOE member firms with "the ability to direct public
orders electronically to the [trading] post and to the Board Broker's
book from their floor communications booths, while reports of orders
executed by the book will be transmitted automatically back to the
firms' wire systems at computer speeds" and (ii) "maintain a computerized
book of public limit orders." 549/ If permitted, NYSE may implement
similar systems. 550/

With the existence of such electronic systems, nationwide limit
order protection for option transactions may be relatively simple to obtain,
More specifically, the feasibility of adapting, or linking, such systems
to form a "central limit order file" for standardized options should

548/ Id., at 1-2.

549/ 1977 Annual Report of the Chicago Board Options Exchange, at 11.

550/ See discussion at 47-48, supra.

1049

be explored. 551/ Of course, the derivative nature of option pricing and
the concerns associated with the different marketmaking systems that the
ootions exchanges use should be considered in connection with any proposal
to establish a central limit order file for options as part of a national
market system. 552/

4 . Off-Board Trading Restrictions
In the January Release, the Commission determined to "defer further
consideration" of remaining off-board trading restrictions until it
'had an ooportunity to evaluate industry and self-regulatory organization

551/ Along these lines, CBOE has stated:

As for a common book for options, OSS could conceivably
be adapted in the future to support several geographically-
dispersed trading floors, if such a capability were
required. However, all of our design studies (beginning
in 1974) suggest that as a practical matter (even if
technically feasible) a common book encompassing more
than one auction market in options would likely be quite
inefficient, counterproductive, and not compatible with
our competing market-maker system. OSS should probably
not be viewed as a vehicle for providing such a facility.

CBOE, OSS Report, 1978, at II-2.

552/ In addition to the points that CBOE has raised concerning the

problems that a central limit order file may present, the effect
that such a file may have on the income of options specialists
should be considered, particularly if such specialists would
lose the brokerage that they now receive when executing
option limit orders. See discussion at 130, supra.

1050

responses to the national market system initiatives" it had announced. 553/
As the Commission continues its review of these restrictions, it may wish
to include similar restrictions that are in effect at the options
exchanges. 554/

553/ January Release, supra , n.176, at 41.
554/ See n.330 and n.337, supra.

1051

EXHIBITS TO CHAPTER VIII

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1052

Table 2:

Sunroary of Price Continuity Data for Call
Options Multiply Traded on CBOE and AMEX*

Option

Average Variation in
Price Per Transaction for
the Three Months Prior
to Initiation of Multiple
Trading (in cents)

Average Variation in
Price Per Transaction for
the Three Months Following
Initiation of Multiple
Trading (in cents)

Burroughs Corp.

Dupont de Nemours
and Co.

Digital Equipment
Corporation

Disney Productions

Merrill Lynch and
Co., Inc.

National Semiconductor
Corporation

Tandy Corp.

9.0 (AMEX)

11.4 (AMEX)

8.0 (AMEX)

5.3 (AMEX)

3.1 (AMEX)

2.5 (CBOE)

5.8 (AMEX)

7.1 (AMEX)

9.2 (AMEX)

5.7 (AMEX)

3.9 (AMEX)

2.3 (AMEX)

2.6 (CBOE)

5.0 (AMEX)

Average :

6.4

Average:

5.1

* American Express, Bally Mfg and MGIC were simultaneously listed by
CBOE and AMEX. As a result, these classes are not included in this table.

1053

Table 3: Summary Bid/ Ask Spread Data For Call
Options Multiply Traded on the
CBOE and AMEX*

Option

Average Bid/Ask Spread for Average Bid/Ask Spread for

the Three Months Prior to the Three Months Following

Initiation of Multiple Initiation of Multiple

Trading (in cents) Trading (in cents)

Burroughs Corp.

Oupont Oe Nemours
and Co.

Digital Equipment
Corp.

Disney Productions

lerrill Lynch and
Co., Inc.

National Semiconductor
Corp.

Tandy Corp.

26.2 (AMEX)

26.6 (AMEX)

25.6 (AMEX)

17.7 (AMEX)
13.9 (AMEX)

11.2 (CBOE)

19.8 (AMEX)

18.7 (AMEX)
21.2 (AMEX)

14.8 (AMEX)

12.6 (AMEX)

11.2 (AMEX)

11.8 (CBOE)

15.0 (AMEX)

Average: 20.1

Average: 15.0

American Express, Bally Mfg. and MGIC were simultaneously listed by

CBOE and AMEX. As a result, these classes are not included in this chart.

40-940 O - 79 - 69

1054

Table 4: Total Contract Volume for Call

Options Listed on Both AMEX and CBOE

Total Contract Volume
For Three Months Prior
to Initiation of
Multiple Trading

AMEX

CBOE

Total Contact Volume For
Three Months Following
Initiation of Multiple Trading

AMEX

CBOE TOTAL

1. Burroughs Corp.

58,250

57,436 78,869 136,305

2. Oupont De Nemours
and Co.

74,713

118,032 138,230 256,262

3. Digital Equipment 237,618
Corp.

155,743 174,336 330,079

4. Disney Productions 107,023

93,752 71,476 165,228

5. Merrill Lynch and 161,026
Co., Inc.

100,030 78,216 178,246

6. National Semi-
conductor Corp.

292,707

66,796 243,166 309,962

7. Tandy Corp.

112,948

76,440 63,365 139,805

L055

Table 5: Sunrary Price Continuity Data for Call

Options Multiply Traded on Both a Primary
and Secondary Exchange*

Average Variation in Price Between
Transactions for the Three Months
Prior to Initiation of Multiple
Option Trading (in cents)

Average Variation in Price Between
Transactions for the Three Months
Following Initiation of Multiple
Trading ( in cents)

Disney Produc-
tions
AMEX-PSE

9.5 (AMEX)

6.6 (AMEX)

Boise Cascade

Corp.
PHLX-CBOE

Merrill Lynch &

Co., Inc.
AMEX-PSE

3.9 (PHLX)

7.6 (AMEX)

4.2 (PHLX)

5.1 (AMEX)

Polaroid Corp.
CBOE-PSE

RCA Corp.
CBOE-PSE

U.S. Steel

Corp.
AMEX-PSE

4.1 (CBOE)

3.4 (CBOE)

5.5 (AMEX)

3.6 (CBOE)
2.9 (CBOE)
6.2 (AMEX)

Xerox Corp.
CBOE-PSE

3.7 (CBOE)

3.5 (CBOE)

Average : 5.4

Average: 4.6

Teledyne Corporation options which were multiply traded on CBOE, PSE, and
PHLX are not included in this table because completed data was not submitted
for that option class.

1056

Table 6: Summary Bid/Ask Spread Data for Call Options
Multiply Traded on Both a Primary and
Secondary Exchange *

Option

Average Bid/Ask Spread For
the Three Months Prior to
Initiation of Multiple
Trading (in cents)

Average Bid/Ask Spread For
the Three Months Following
Initiation of Multiple
Trading (in cents)

Disney

Productions
AMEX-PSE

Boise Cascade

Corp.
PHLX-CBOE

Merrill Lynch &

Co., Inc.
AMEX-PSE

Polaroid Corp.
CBOE-PSE

RCA Corp.
CBOE-PSE

U.S. Steel Corp.
AMEX-PSE

Xerox Corp.
CBOE-PSE

30.3 (AMEX)

22.3 (PHLX)
22.6 (AMEX)

16.6 (CBOE)
15.5 (CBOE)

27.7 (AMEX)

18.4 (CBOE)

22.8 (AMEX)

22.8 (PHLX)

16.2 (AMEX)

15.7 (CBOE)

15.1 (CBOE)

22.3 (AMEX)
18.0 (CBOE)

Average: 22.0

Average: 19.0

Teledyne Corporation options which were mutiply traded on CBOE, PSE,
and PHLX are not included in this table because complete data was not
submitted for that option class.

1057

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1059

Table 8A: Weekly Average Bid/ Ask Spread for DuPont Corp.
Call Options on AMEX for the Three Months Prior
to and Following Initiation of Multiple Trading

Total

% 1/16

% 1/8

% 1/4

% 3/8

% 1/2

Average

# of.

Point

Bid/Ask

Wk. End.

Quotes

or Less

Spread

12/ 3/76

700

8.1

38.0

68.9

99.9

100.0

23.60

12/10/76

1,085

6.5

33.6

65.8

98.5

24.70

12/17/76

1,393

3.5

27.9

70.6

99.5

99.9

25. 0C

12/23/76

1,319

5.8

27.1

61.3

94.5

100.0

26.80

12/31/76

1,215

4.8

24.4

58.2

95.1

99.9

27.50

1/ 7/77

1,003

3.7

18.8

54.4

95.0

99.9

28.80

VH/77

1,222

5.4

32.0

59.3

94.8

99.7

26.30

1/21/77

1,042

7.5

31.2

60.6

93.6

100.0

26.40

1/28/77

1,081

2.5

22.5

59.1

99.5

99.9

27.20

2/ 4/77

1,207

20.6

52.8

96.5

96.6

27.10

2/11/77

1,080

3.7

23.7

55.9

99.8

99.9

27.30

2/18/77
Total:

1,383
13,730

4.5
4.8

23.7
26.9

58.3
60.7

98.3
97.5

99.9
99.9

27.20
26.60

3/ 4/77

1,286

6.7

41.5

99.6

100.0

19.40

3/11/77

1,333

5.3

39.3

• 99.6

100.0

19.80

3/18/77

1,575

3.2

33.2

99.6

100.0

20.. 70

3/25/77

1,515

4.7

32.1

97.3

99.7

100.0

21.00

4/ 1/77

2,021

6.9

33.9

94.9

99.3

99.8

21.00

4/ 7/77

928

10.0

45.7

99.8

99.9

100.0

18.70

4/15/77

1,615

7.3

32.3

89.8

98.3

100.0

21.90

4/22/77

1,366

2.7

27.7

98.2

99.6

99.9

21.60

4/29/77

1,234

5.4

32.9

75.7

100.0

23.40

5/ 6/77

1,037

8.2

42.2

809.1

99.9

100.0

21.70

5/16/77

794

8.9

41.0

71.5

99.7

22.80

5/20/77
Total:

885

15,589

7.9
S7I

40.0
36T0

72.4
9T3

98.8
9"9"77

100.0
~W3

23.00

2"Oo

1060

Table 8B:

Weekly Average 1

Bid/Ask Spread for

DuPont Corp.

Call Options on

CBOE for

the Three Months

Following

Initiation of Multiple

Trading

1/16 to

1/8 to

1/4 to

Less than 1/8

Less than 1/4

Less than 1/2

More than 1/2

Average

No. of

% of

No. of

% of

No. of

% of

No. of % of

Bid/Ask

Wk. End.

Quotes Quotes

Spread

3/ 4/77

1,353

62.2

813

37.4

0.4

16. 6<=

3/11/77

1,390

60.8

887

38.8

0.4

16. 6C

3/18/77

1,287

52.4

1,155

47.0

0.4

5 0.2

18. 2C

3/25/77

1,255

47.7

1,342

51.0

1.2

1 0.1

18. 7C

4/ 1/77

1,679

54.0

1,412

45.4

0.5

1 0.1

17. 4C

4/ 7/77

1,272

60.2

832

39.4

0.4

16. 4C

4/15/77

1,316

46.2

1,505

52.9

0.9

18. 7C

4/22/77

952

39.9

1,431

59.9

0.2

19. 6C

4/29/77

943

54.1

795

45.6

0.3

17. 4C

5/ 6/77

994

55.9

780

43.9

0.1

1 0.1

17. 2C

5/ 3/77

702

52.9

622

46.9

0.2

17.60

5/20/77

906

56.2

701

43.5

0.3

17. 1C

Total:

14,049

53.5

12,275

46.0

TIT

0.4

8 .04

17. 6C

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1063

Tab.

Le 10A:

Weekly Average Bid/£

LSk Spread

for Merril

1 Lynch Call

Options or

AMEX for

the Three

Months Prior

Following

Initiatior

of Multi

pie Trading

Total

% 1/16

% 1/8

% 1/4

% 3/8

% 1/2

Average

# of

Point

Bid/Ask

Wk. End.

Quotes

or Less

Spread

12/ 3/76

970

26.6

71.0

99.9

14. 5C

12/10/76

1,163

27.2

71.7

99.9

100.0

14. 2C

12/17/76

1,108

27.4

70.9

100.0

14.40

12/23/76

717

28.0

70.4

99.5

99.9

100.0

14. 5C

12/31/76

804

38.6

71.0

99.8

100.0

14.30

1/ 7/77

814

28.7

73.2

99.9

100.0

14.00

1/14/77

741

29.1

72.3

100.0

14. 1C

1/21/77

646

26.1

70.4

100.0

14. 5C

1/28/77

568

27.7

71.5

99.8

100.0

14. 4C

2/ 4/77

543

30.6

80.1

98.3

99.6

99.8

13. 3C

2/11/77

495

34.1

86.0

99.8

100.0

11. 90

2/18/77
Totals:

552
9,121

35.7
28.7

90.6
73.9

99.6
99.8

9979

11.50
13. 9C

3/ 4/77

652

47.5

99.6

100.0

9.50

3/11/77

428

51.6

100.0

9.30

3/18/77

516

53.1

100.0

9.20

3/25/77

206

59.2

100.0

8.30

4/ 1/77

193

61.1

100.0

8.7$

V 8/77

158

62.5

100.0

8.60

4/15/77

432

54.8

100.0

9.10

4/22/77

508

30.9

71.8

99.8

100.0

14. 0C

4/29/77

455

31.9

73.9

100.0

13.4C

5/ 6/77

303

26.7

65.0

99.7

100.0

15.10

5/13/77

230

25.2

62.2

100.0

14. 9C

5/20/77
Totals:

382
4,463

28.8
43.3

74.0
87.6

99.4
99.9

99.7
99.9

13.20
11. 20

1064

Table 10B: Weekly Average

Bid/ Ask Spread for Merrill Lynch Call

Options on CBOE for the Three Months

Following

Initiation of

Multiple

2 Trading

1/16 to

1/8

1/4 to

Less than 1/8

Less than 1/4

Less than 1/2

More than 1/2

Average

No. of % of

No. of

% of

No. of % of

Spread

Wk. End.

Quotes Quotes

(In Cents)

3/ 4/77

892 99.8

0.2

- -

7.4

3/11/77

875 99.5

0.5

7.4

3/18/77

915 99.2

0.8

7.6

3/25/77

616 99.8

0.2

7.3

4/ 1/77

547 99.8

0.2

6.9

4/ 7/77

490 99.8

0.2

7.1

4/15/77

706 99.7

0.3

7.8

4/22/77

607 70.1

225

26.0

34 3.9

14.4

4/29/77

504 73.6

177

25.8

3 0.4

1 0.2

18.2

5/ 6/77

514 70.8

209

28.8

3 0.4

13.4

5/13/77

515 77.8

147

22.2

12.2

5/20/77

618 81.2

140

18.4

3 0.4

- -

11.6

[totals

7,799 89.3

916

10.3

43 0.4

T O

1065

Table 11A:

Sumnary

Price Continuity and

Bid/ Ask

Spread Information

Organized by Size

of Option Premium for DuPont

Corporation

Transaction

Data Before

Multiple

Listing (November 29

, 1976 -

February 18,

1977)

Total

% 1/16

% 1/8

% 1/4

% 3/8

% 1/2

Price

# of

point

Avg.

Category

Trans.

% Unch.

or less

Var.

Under 7/16

135

66.5

96.2

100.0

2.3C

1/2 - 15/16

275

50.7

92.7

100.0

3.6<

1-1 15/16

1,375

42.4

76.7

98.4

100.0

5.5<

2-3 7/8

1,218

40.0

57.1

92.2

99.0

99.7

99.9

7.5<

4-5 7/8

2,222

42.2

82.1

97.7

99.3

99.9

9.9<

6-7 7/8

1,049

38.0

72.2

94.3

97.1

98.5

12. 8<

8-9 7/8

877

34.1

67.1

89.2

95.2

98.4

14. 9<

10 - 14 7/8

1,497

29.0

57.0

81.4

91.2

95.0

19. 5<

15-19 7/8

955

24.6

51.2

76.4

89.4

94.4

22. 0C

Above 20

24.2

47.0

75.8

80.3

84.8

26. 3<

Total:

9,673

38.2

47.1

78.3

92.4

563

98.2

11. 9<

Transaction Data After Multiple Listing (February 28 - May 20, 1977)

Under 7/16

588

69.2

98.3

100.0

2.0<

1/2 - 15/16

430

52.2

94.7

100.0

3.4C

1-1 15/16

705

44.2

79.1

96.3

99.7

100.0

5.1C

2-3 7/8

2,744

45.7

66.9

94.6

99.1

99.9

100.0

6.2C

4-5 7/8

1,573

43.7

84.4

97.5

99.2

99.7

9.5<

6-7 7/8

1,201

37.6

75.4

92.6

97.9

99.4

12. 3C

8-9 7/8

1,299

38.3

74.4

92.0

96.3

98.7

12. 7C

10 - 14 7/8

1,561

36.5

71.9

87.3

94.2

97.3

14. 9^

15-19 7/8

123

20.3

46.3

71.5

82.9

87.0

27. 1<

Above 20

. -

Total:

10,224

43.3

54.7

84.7

95.2

98.0

99.1

9.4<

1066

Table

11A Summary Price

Continuity and Bid/Ask Spread

Information

Organized by

Size of Opt

;ion Premium for DuPont

Corporation

Quotation Data Before Multiple Listing (November 29,

1976 - February 18,

1977)

Total

% 1/16

% 1/8

% 1/4

% 3/8

% 1/2

Average

Price

# of

point

Quotation

Category

Quotes

or less

Spread

Under 7/16

180

54.5

100.0

9.2C

1/2 - 15/16

307

33.0

99.6

100.0

10. 5C

1-1 15/16

1,276

14.1

93.8

100.0

12. 8$

2-3 7/8

1,465

6.1

48.5

99.6

100.0

18. 4C

4-5 7/8

2,717

23.4

91.0

100.0

23.2$

6-7 7/8

1,566

12.1

57.1

100.0

28. 8C

8-9 7/8

1,589

9.6

46.2

99.7

99.9

30. 6C

10 - 14 7/8

3,393

4.7

24.1

97.9

99.9

34. 2C

15 - 19 7/8

1,103

3.5

17.3

87.5

100.0

36. 5C

Above 20

134

1.6

11.4

35.5

99.2

44.4$

Total:

13,730

26.4

60.8

97.8

99.9

26.TS

May 20, 1977

Under 7/16

521

58.

99.6

100.0

8.9C

1/2 - 15/16

401

35.

99.6

100.0

10. 3C

1-1 15/16

892

18.

94.9

100.0

11.8$

2-3 7/8

3,189

11.

66.2

99.9

100.0

15. 9C

4-5 7/8

2,131

27.9

99.3

99.8

100.0

21. 6C

6-7 7/8

2,263

16.5

89.0

97.7

100.0

24. 3C

8-9 7/8

2,441

14.9

78.2

99.6

100.0

25. 9C

10 - 14 7/8

3,233

12.1

84.6

99.1

100.0

25. 5C

15 - 19 7/8

518

2.3

97.7

99.8

100.0

25.00

Above 20

Total:

15,589

6.2

36.0

91.6

99.7

100.0

1007

Table

11B:

Summary Price Continuity and Bid/ Ask Spread Information

Organized by Size of

Option Premium for

Burroughs

Corporation

Transaction Data Before Multiple

Listing (November 29,

1976 -

February 18,

1977)

Total

% 1/16

% 1/8

% 1/4

% 3/8

% 1/2

Price

# of

point

Avg.

Category

Trans.

% Unch.

or less

Var.

Under 7/16

515

66.1

100.0

2.10

1/2 - 15/16

960

50.6

93.6

99.8

100.0

3.6C

1-1 15/16

1,246

40.2

80.5

97.9

99.8

99.9

5.20

2-3 7/8

1,794

40.4

62.5

94.1

99.4

99.7

99.8

7.2$

4-5 7/8

1,423

40.9

82.2

96.7

99.3

99.6

10. 20

6-7 7/8

965

30.9

65.0

88.5

96.2

98.3

15.20

8-9 7/8

451

23.3

57.6

80.5

92.8

96.6

19.30

10 - 14 7/8

374

24.6

51.4

76.5

85.6

93.2

21.70

15 - 19 7/8

13.2

47.4

71.0

84.2

89.5

29. 9C

Above 20

41.2

76.5

100.0

10.30

Total:

77783

4T79

60.1

8TT6

95.4

58TT

9*9TT

~Oo

\ nsaction Data After

Multiple Listing (February 28 -

May 20,

1977)

Under 7/16

468

68.1

99.7

100.0

2.10

1/2 - 15/16

975

51.7

94.7

99.8

100.0

3.40

1-1 15/16

1,611

41.1

83.5

98.1

100.0

4.90

2-3 7/8

1,577

39.4

63.4

93.3

99.0

99.9

100.0

6.90

4-5 7/8

1,070

39.0

85.5

98.0

99.7

100.0

9.70

6-7 7/8

457

31.6

73.1

89.6

94.9

98.0

14.30

8-9 7/8

184

24.2

57.7

82.4

91.8

95.6

19.00

10 - 14 7/8

103

13.6

34.0

73.8

84.5

90.3

27.90

15 - 19 7/8

Aoove 20

Total:

67445

4272

673

9T3

~9"7T8"

997T

T^c

1068

Table 11B:

Summary Price Continuity and Bid/Ask Spread Information

Oganized by

Size of

Option Premium for

Burroughs

Corporation

Quotation Data Before

Multiple Listing (November 29,

1976 - February 18,

1977)

Total

% 1/16

% 1/8

% 1/4

% 3/8

% 1/2

Average

Price # of

point

Quotation

Category Quotes

or less

Spread

Under 7/16 431

49.7

98.2

100.0

„

9.80

1/2 - 15/16 886

38.4

91.9

99.1

99.7

100.0

10.90

1-1 15/16 1,287

17.1

72.1

99.1

99.7

99.9

13. 70

2-3 7/8 2,419

8.3

48.2

92.6

99.3

100.0

18. 40

4-5 7/8 2,108

18.0

62.1

96.6

100.0

27.90

6-7 7/8 1,791

5.2

31.3

84.0

100.0

34.90

8-9 7/8 1,008

3.5

19.9

65.8

99.9

38.80

10 - 14 7/8 1,219

3.3

11.6

35.9

100.0

43.60

15 - 19 7/8 163

4.3

13.6

100.0

47.70

Aoove 20 37

~8T6

10.8
34.3

54.0
62.2

100.0
85.5

29.40

*al: 11,349

99.9

26.30

Quotation Data After Multiple Listing (February 28 - May 20, 1977)

Under 7/16

529

51.2

98.6

100.0

9.50

1/2 - 15/16

1,139

34.6

98.8

100.0

10.40

1-1 15/16

1,993

20.7

93.4

100.0

11.70

2-3 7/8

2,148

7.6

60.0

99.6

100.0

16.80

4-5 7/8

1,666

17.9

95.5

100.0

23.30

6-7 7/8

979

10.0

74.7

99.7

100.0

27.30

8-9 7/8

885

3.2

66.5

97.5

100.0

29.10

10 - 14 7/8

618

1.5

68.8

97.3

100.0

29.10

15 - 19 7/8

93.3

100.0

26.70

Above 20

1274

5272

ToO

Total:

9,972

91.8

99.6

18.60

1069

Table 11C: Summary Price Continuity and Bid/Ask Spread Information
Organized by Size of Option Premium for Digital
Equipment Corporation

Transaction Data Before Multiple Listing (November 29, 1976 - February 18, 1977)

Price

Category

Total
# of

Trans. % Unch.

% 1/16
point

% 1/8
point
)r less

% 1/4
point

% 3/8

point

or less

% 1/2

point

Avg.
Var.

Under 7/16

1/2 - 15/16

1-1 15/16

2-3 7/8

4-5 7/8

6-7 7/8

8-9 7/8

10 - 14 7/8

15 - 19 7/8

Above 20

Total:

1,208
2,358
3,473
6,386
3,812
1,677
941
542

20,397

60.6
50.3
47.7
42.5
40.9
33.5
29.8
29.8

99.0
93.5
81.8
59.8
40.9
33.5
29.8
29.8

623

100.0
99.6
98.5
92.7
81.2
68.2
57.8
49.7

"SO

100.0
99.8
99.4
96.1
89.2
83.3
72.2

~56T7

99.9
99.8
98.7
95.9
90.2
80.6

98.4

99.9
99.9
99.8
98.4
96.5
87.5

2.6C
3.9C

4.9C
7.1C
10. 4C
14. 6C
18. 5C
25. 7C

99T3 ~8"72C

1977)

Under 7/16

1,440

62.6

98.0

99.9

100.0

2.4C

V2 - 15/16

1,824

51.0

94.8

99.5

99.9

100.0

3.4C

1-1 15/16

3,619

41.4

87.6

98.9

99.9

4.5C

2-3 7/8

3,722

41.4

68.5

95.8

99.6

99.9

100.0

6.1C

4-5 7/8

1,571

35.2

84.6

98.3

99.7

100.0

10. 3C

6-7 7/8

419

32.9

75.7

93.6

97.0

98.5

12. 9C

8-9 7/8

123

33.1

71.2

88.1

92.4

94.9

15. 5C

10 - 14 7/8

40.0

60.0

50. 0C

15 - 19 7/8

Aoove 20

Total:

12,723

44.0

75.2

95.4

99.3

99.8

99.9

5.7C

1070

Die 11C:

Summary Price Continuity and Bid/ Ask Spread Information

Organized by Size

of Option

Premium for

Digital

Equipment Corporation

Quotation Data

Before Multiple Listing (November 29,

1976 - February 18,

1977)

Total

% 1/16

% 1/8

% 1/4

% 3/8

% 1/2

Average

Price

# of

point

Quotation

Category

Quotes

or less

Spread

Under 7/16

724

48.5

96.1

100.0

9.8C

1/2 - 15/16

1,562

40.0

88.6

100.0

10. 7C

1-1 15/16

2,779

23.3

70.1

98.8

100.0

13.7C

2-3 7/8

5,466

5.5

37.1

81.8

98.9

99.9

21. 8C

4-5 7/8

3,881

14.4

50.7

91.2

100.0

30. 5C

6-7 7/8

2,124

5.2

26.9

63.6

100.0

38. 0C

8-9 7/8

1,490

1.7

15.3

37.1

99.8

43. 1C

10 - 14 7/8

1,048

0.3

8.5

12.9

98.0

47. 7C

15 - 19 7/8

Above 20

Total:

19,074

io.:

35.4

64.8

84.2

99.9

25. 9C

Quotation Data After Multiple Listing (February 28 - May 20, 1977)

Under 7/16

1,284

53.4

99.4

100.0

„

—

9.2C

V2 - 15/16

1,525

43.8

99.5

100.0

9.8C

1-1 15/16

2,975

29.0

97.1

99.9

100.0

10. 9C

2-3 7/8

3,389

11.1

67.7

99.7

100.0

15. 7C

4-5 7/8

1,759

23.9

99.5

100.0

22. 1C

6-7 7/8

763

14.8

98.6

100.0

23. 3«

8-9 7/8

265

7.2

98.4

100.0

24. 3C

10 - 14 7/8

93.3

100.0

25.8$

15 - 19 7/8

2177

— =-

Above 20

11,975

99.7

100.0

14. 7C

1071

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1073

Table 14: Exchange Market Share in Options Which

Were Multiply Traded for Selected Days From
February 24, 1977 through August 31, 1977*

Date CBOE AMEX PHLX PSE MSE

Feb.

24 1/

66.0

31.9

1.16

March

68.1

29.2

1.90

March

64.7

34.2

March 16

67.7

29.9

1.0

1.3

March

70.6

27.6

1.3

March

31 2/

69.3

28.0

1.7

April

72.2

24.7

2.4

April

69.8

27.8

1.6

April

70.5

24.0

2.6

2.8

April

71.5

21.8

5.0

1.8

May

74.9

21.7

1.5

1.9

May

80.7

13.0

3.7

2.7

May

67.2

30.8

1.2

May

69.8

26.3

1.2

1.9

June

78.2

18.3

2.8

June

67.8

30.0

1.5

June

66.7

29.8

2.5

June

70.4

25.5

1.2

1.7

1.6

June

68.9

28.0

2.2

July

76.3

22.2

1.2

July

12 2/

67.6

30.1

1.0

July

76.9

20.9

1.4

July

71.4

25.6

1.5

1.1

Aug.

74.4

23.6

1.1

Aug.

76.4

22.0

1.5

Aug.

65.0

33.7

1.1

Aug.

71.1

27.4

Aug.

75.4

23.6

TOTALS
Mean % 71.05 26.13 1.04 1.53 .35

Data dervied from a Directorate of Economic and Policy Research
Memorandum to the Commission dated June 5, 1978, p. 19, Table 1,

1/ February 24 was used instead of February 23 because of the un-
availability of data for earlier date.

V The dates indicated were used instead of March 30 and July 13
respectively because of a computational error in the OCC data
for those dates which would bias the results.

1074

Table 15: Contract Volume and Market Share of

the CBOE and AMEX for August 19781

CBOE

Market Share

AMEX

Market Share

American Express

2,552

35.3%

4,676

64.7%

Bally Manufacutring
Corporation

102,532

45.8%

121,174

54.2%

Burroughs Corp.

4,149

5.4%

72,617

94.6%

Digital Equipment
Corporation

25,806

39.5%

39,442

60.5%

Disney Productions**

7,452

16.4%

37,879

83.2%

DuPont de Nemours
and Co.

10,938

25.8%

31,416

74.2%

Merrill Lynch &
Co., Inc.

18,411

15.6%

99,502

84.4%

MGIC Investment

6,184

20.9%

23,405

National Semi-
conductor Corp.

94,170

62.2%

57,341

37.8%

Tandy Corporation

6,239

9.2%

61,829 90.8%

* Data derived from PHLX submission in response to Securities and
Exchange Release No. 14854, Appendix C.

** .4% of total volume was traded on the PSE.

1075

Table 16: CBOE Monthly Contract Volume and Market Share for
American Express, Bally Mfg., Digital Equipment

Expr
>nal

and National Semiconductor Fr

Lgital
T7I7T

8 to 10/31/78

CBOE

Toted

Public Customer

# of

CBOE %

# of

CBOE %

Month

Contracts

of Total

Contracts

of Total

American

Jan.

5,439

2,018

Express

Feb.

2,439

1,098

Mar.

3,442

1,722

Apr.

11,923

5,311

May

8,104

4,417

June

8,819

3,977

July

5,272

2,161

Aug.

7,656

3,257

Sept.

7,362

3,292

Oct.

8,264

2,951

Bally

Jan.

20,329

8,818

Mfg.

Feb.

18,819

7,697

Mar.

53,195

21,491

Apr.

97,602

42,194

May

135,084

61,522

June

197,532

87,744

July

140,448

57,385

Aug.

315,973

147,817

Sept.

389,499

182,324

Oct.

337,621

148,260

Digital

Jan.

138,252

34,482

Equipment

Feb.

71,718

16,304

Mar.

67,277

16,424

Apr.

130,338

45,282

May

121,026

43,923

June

113,063

40,999

July

97,430

33,405

Aug.

71,871

25,652

Sept.

44,405

14,808

Oct.

59,935

19,251

National

Jan.

55,467

18,522

Semi-

Feb.

41,380

16,131

conductor

Mar.

67,933

25,770

Apr.

115,910

53,460

May

179,149

84,950

June

78,623

33,397

July

70,128

29,346

Aug.

162,723

78,517

Sept.

120,429

50,272

Oct.

113,379

41,869

1076

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1081

Table 19: Total Options Revenue For Secondary Exchanges
and Percentage of Total Exchange Revenues

1976

1977

3/31/78

Options

Revenues

Percentage of
Total Exchange
Revenues

Options
Revenues

Percentage of
Total Exchange
Revenues

Options
Revenues

Percentage of
Total Exchange
Revenues

PHLX

$802,187

36 %

$1,111,136

42.5 %

$251,949

42 %

PSE 1/

$843,000

18 %

$2,126,000

33 %

$604,000

37 %

nse y

$ 14,524

.54%

$ 615,173

2.26%

$207,730

6.99%

Table 20: Total Options Net Income For Secondary Exchanges
and Percentage of Total Exchange Net Income

1976

1977

3/31/78

Options

Net

Income

Percentage of
Total Exchange
Revenues

Options
Net

Income

Percentage of
Total Exchange
Revenues

Options
Net

Income

Percentage of
Total Exchange
Revenues

PHLX

$ 202,413

75.6 %

$ 143,060

186.7 %

$ 9,716

- 0 -

pse y

$ (898)

-0-3/

$ 131,000

30 %

$116,000

153 %

MSE 2/

$(267,531)

-0-3/

$(556,596)

- 0 - 3/

$ 99,295

- 0 - 3/

Table 21: Total Revenues Derived Prom Option Transaction
Charges on Secondary Exchanges and Percentage of
Total Options Revenues

1976

PHLX

Total Revenues
Derived Pram
Option Trans-
action Charges

$471,360

Percentage

of
Revenues

59%

1977

Total Revenues
Derived Prom
Option Trans-
action Charges

$727,647

Percentage

of
Revenues

65%

3/31/78

Total Revenues
Derived Prom
Option Trans-

action Charges

$154,903

Percentage

of
Revenues

PSE y
MSE 2/

$157,873
$ 3,558

19%
25%

$636,169
$148,583

30% $189,658
24% $ 65,353

31%
31%

1/ Options program was began in 4/76.

y Options program was began in 12/76.

3/ The exchange showed a net loss for this period.

1082

Table 22: CBOE Table A: NYSE Market Share

1. Distribution of Total Market for Multiply-Traded Common

Stocks Listed on NYSE (Percentage of consolidated tape volume)

Year

NYSE

AMEX

PHLX

PSE

MSE

Third
Market

1976

84.16%

0.01%

1.49%

3.70%

4.45%

4.72%

1977

84.72%

0.03%

1.40%

3.57%

4.74%

3.83%

Source:

NYSE, 1977 Annual Report of the
Markets Committee, Exhibit E.

Quality

In 1977, NYSE had at least 70 percent of the market in all
but 4 percent of its listings. On a monthly basis in 1977, NYSE re-
tained 100 percent of total consolidated volume in approximately 29
percent of its listed common stocks, and retained market share of 90
percent or better in more than 69 percent of its listed stocks.

Source: NYSE, 1977 Annual Report of the Quality of Markets
Committee, pp. 18-19.

2. NYSE Share of Trading of Shares on All Registered Securities
Exchanges

Percent of
Dollar volume

87.3
86.0
82.0
78.7
85.2
84.4
84.0

Percent of

Year

Share Volume

1935

77.6

1950

76.5

1965

69.9

1970

70.8

1975

81.1

1976

80.3

1977

79.9

Source:

NYSE,

1978 Fact Book, i

1083

Table 23: CBOE Table B: Distribution of Market in Certain
Common Stocks Selected and Eligible for Exchange
Option Trading

A. Stocks Selected for Option Trading (percent)

NYSE PHLX PSE MSE NASDAQ
Mean Proportion of
Dollar and Share
Volume 81.35 1.63 4.39 5.80 4.88

Mean Proportion of

Number of Trades 78.56 1.76 8.03 5.55 2.98

B. Stocks Eligible (but not selected) for Option Trading (percent)
NYSE PHLX PSE MSE NASDAQ

Mean Proportion of
Dollar and Share
Volume

82.35

1.74

3.16

5.63

4.67

Mean Proportion of
Number of Trades

81.93

2.17

5.34

4.43

2.31

Source: SEC calculations using data from Susan M. Phillips
and Peter G. Martin, "An Analysis of the Distribution of Listed Security
Volume over Primary Exchanges, Regional Exchanges and the Third and
Fourth Markets," Directorate of Economic and Policy Research's Off -Board
Trading Memorandum to the Commission, March 3, 1977. The Phillips-Martin
study was based on an analysis of distribution of trading volume (dollar
volume, share volume, and number of trades) among markets for some 854
stocks during the week of March 21-25, 1977. Tables A and B above are
based on further analysis of the distribution of trading volume among
markets for, repectively, some 216 stocks which were selected for option
trading and some 168 stocks eligible but not selected for option trading
at March 21-25, 1977, all of which were listed on the NYSE and at least
one other exchange.

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